Category Archives: Cryptocurrency Issues

Recap of Crypto Discussion Forum

On September 2nd we held our crypto discussion forum where we discussed legal, tax and compliance issues related to the digital asset space. The below is a quick recap the event from panelist Justin Schleifer of Aspect Advisors. We’ll keep updating everyone through this blog on future events as well.

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Thank you for attending our “Cryptocurrency and Digital Asset Forum: Trends in Legal, Tax, and Compliance” webinar last week. I would also like to extend many thanks to my fellow panelists, Ryan David Williams of Ashbury Legal and Nick Cerasuolo of Blockchain Tax Partners, and to Bart Mallon of Cole-Frieman & Mallon for hosting.

We had a very interesting and lively interactive discussion about putting crypto investments to work through yield and lending, and DeFi implications including market-making, governance and custody issues.

Here are my favorite tidbits from the various speakers:

Each state has their own regulations as well, and everyone is on different parts of the learning curve. People have to address the nuances of each individual state. States may not agree with the idea of a custodian. DeFi is just way out there for them. They’re still on this idea of what is a custodian in the crypto space? Just getting over that hurdle has proven to be very difficult. – Bart

With the advent of crypto/blockchain, we almost went back in time because are used to dealing with USD. It’s obvious when something is taxable. Crypto took us back to the stone age where we’re back to barter model; property for property (BTC for ETH). You have transactions that don’t involve fiat at all. Tax event triggers are traps for the unwary. It’s not always obvious when a transaction is taxable. – Nick

Insider trading is absolutely an issue in this industry, and it’s getting more nuanced. Firms in the venture capital space get involved with companies on working on their protocols and Dapps. You can very well come in contact with all types of MNPI, so both sides must evaluate what is material or public. You have to restrict yourself in certain areas and not commit to certain trading activities. – Justin

There was a fantasy that once you achieve decentralization, laws are gone. This is an ethos that a decentralized exchange doesn’t need KYC/AML. We are now dispelled of that notion (i.e. the SEC went after the founder of a crypto exchange). The CFTC has also said they will go after software developers. This is the concept of causing a violation of securities law. The expectation of profits is based on the efforts of others. The manager is doing all the work, but what do we do when there is no sponsor and the work is done by community participants? We haven’t finalized this yet. ETH is officially decentralized, so it doesn’t make sense to apply traditional securities laws. – Ryan

If you (or your friends or 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 any of the above topics, 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

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Bart Mallon is a founding partner of Cole-Frieman & Mallon LLP.  Cole-Frieman & Mallon LLP has been instrumental in structuring the launches of some of the first cryptocurrency focused hedge funds. If there are any questions on this post, please contact Mr. Mallon directly at 415-868-5345.

Crypto Discussion Forum Tomorrow!

Tax, Compliance and Legal for the Digital Asset Space – Ask Your Questions

Tomorrow, September 2nd, at 10am PT we will be hosting an open question and answer discussion forum on issues affecting the digital asset space. We have a number of interesting topics to explore from the legal, tax and compliance side including:

  • Yield and lending trends and consequences
  • DeFi, DeFi, DeFi
  • Market Making
  • Custody
  • Regulatory update and what this means for different groups (managers, stakers, custodians, etc)

Speakers include:

  • Bart Mallon, Cole-Frieman & Mallon
  • Ryan David Williams, Ashbury Legal
  • Justin Schleifer, Aspect Advisors
  • Nick Cerasuolo, Blockchain Tax Partners

To register for forum, please go here.

To submit a question, please go here

Look forward to seeing you then!

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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.

Cryptocurrency / Digital Asset Forum – Ask us your questions!

Open Forum on September 2nd for Legal, Tax & Compliance Questions

There are a ton of hot topics in the digital asset space right now – the price of Bitcoin, DeFi, staking, lending, venture capital, etc – and we want to answer your questions in a unique format where the experts answer your questions directly.  Our firm is teaming up with Asbury Legal, Aspect Advisors and Blockchain Tax Partners to host a live discussion where we will talk about what you want to talk about.

To register for webinar, please go here.

To submit a question, please go here

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September 2, 2020 10:00am Pacific / 1:00pm Eastern

The Host: Bart Mallon, Cole-Frieman & Mallon as Host

The Panel:

Ryan David Williams, Ashbury Legal

Justin Schleifer, Aspect Advisors

Nick Cerasuolo, Blockchain Tax Partners

Join us to get your questions answered by an expert panel during a Live Discussion. Experience a unique collaborative event to explore the latest developments in the Cryptocurrency and Digital Asset sector. Suggested topics for this session include (but are in no way limited to):

•    Putting Crypto Investments to Work:  Unlocking Full Potential Through Yield and Lending

•    DeFi Implications: Market-Making (Liquidity), Governance, and Custody

•    Evolving Landscape: Latest Products/Services, Regulations, and Enforcements

Submit your questions in advance and we’ll have answers prepared.   You’ll also be able to ask questions during the interactive discussion.  We’re excited to talk about anything you want!

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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.

CoinAlts Webinar – May 14th at 11am PT

Cole-Frieman & Mallon Presenting a Digital Asset Legal Update for 2020

We are excited to present our first webinar to update the industry on the various updates applicable to digital asset managers. We will be providing the US legal update during the webinar and will be covering the following topics:

  • Proposed Laws (state and federal)
  • Wyoming Update
  • SEC Digital Asset Priorities
  • The Courts
  • Structuring Trends

Below is our invitation for the event – it is free to join and all are welcome. Look for coming posts providing an overview of the content from the webinar. As always, please contact us if you’d like to be added to any mailing lists.

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With the rescheduling of our 2020 CoinAlts Fund Symposium to Fall of 2021, we are excited to announce our new CoinAlts Webinar Series, beginning on Thursday, May 14th at 11:00am PT.

Hear from industry experts on the investment, legal and operational issues that digital asset managers are facing in today’s climate. 

After the panel, we are excited to host a Q&A session with Matt Perona from Polychain Capital. 

Webinar details: 

·    Title: CoinAlts Fund Symposium Webinar Series 

·    Date: Thursday, May 14th

·    Time: 11:00am – 12:00pm PT

·    Registration: Click here to register

If you would like to submit a question for consideration to one of the founding sponsors or Matt Perona, you will have the opportunity to do so upon registration. For those unable to join, the webinar will be available for replay within 24 hours.

We look forward to having you! 

All the best, 

Cole-Frieman & Mallon LLP

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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.

Bitcoin Mining Panel Event in San Francisco

CFM & Aspect Advisors Sponsor Mining Discussion

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

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

This event will feature the following panelists:

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

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

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

Allocator Perspectives in Digital Assets – Panel Discussion

On November 19 Cole-Frieman & Mallon hosted an event for managers and investors in the digital asset and cryptocurrency space.  Below are notes from the panel discussion.

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Many thanks to all who made our event this week such a success, especially Moderator, Michael Arrington (Arrington XRP Capital) and Panelists, Aram Verdiyan (Accolade Partners), Brooke Pollack (Hutt Capital), Thomas Chladeck (Diginex), and Nabeel Qadri (Protocol Ventures).

Discussion was animated and at brief moments entertainingly off topic but within our hour-long panel we touched on many core issues:

  • Allocators must answer to their own investors/limited partners – currently demand (from endowments, institutions, family office, etc) for digital asset products is not high.
  • We discussed the Bitwise study on allocating crypto in an institutional portfolio.  While that study makes clear the potential positives, the panel was divided on whether exposure to digital assets should be done through FOF vehicles or simply through holding bitcoin at one of the large custodians (Coinbase Anchorage, Fidelity, etc).
  • The panel discussed a broad spectrum of digital asset investment styles – from VC type strategies to long tokens/protocols to trading strategies, acknowledging there are pros and cons with each.  Ultimately panelists were split on what the right mix might be and opinions were informed by their time-horizon preferences.
  • Opinions varied on portfolio construction.  Some believe that protocol layers are the correct play and that businesses will eventually be built on the protocol layers.  Others believe the industry is so much in its infancy that the bets need to be placed on development teams/companies who can develop and pivot as necessary.
  • The panelists agreed that manager pedigree is an important measure of due diligence and the allocators will generally look to a manager’s understanding of the space, their technical capacity and knowledge, and their historical presence in the space.  One panelist noted it is not uncommon to find managers with 5-6 year portfolios.
  • The topic of timing was big – many of the panelists did not think they had the ability to specifically time the market and that all investments in this space should really be focused on the long term prospects of the industry as a whole.
  • Everyone seemed to agree that the digital asset space is waiting for its Lotus123 moment.  As of now it appears Bitcoin is both the religion and killer app even as there are various trends which pop up from time to time (DeFi as the trend right now).

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

Blockstack Regulation A+ Token Offering

Overview of the Regulation A+ Offering Circular for Crypto Tokens

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

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

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

What is Blockstack & the Stacks Token?

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

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

$50M Regulation A+ Raise

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

Cash Program

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

App Mining Program

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

Other Aspects of the Offering and Business

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

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

Legal Issues Presented

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

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

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

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

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

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

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

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

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

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

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

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

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

Conclusion

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

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

Bitcoin ETF – Bitwise Asset Management

Cole-Frieman & Mallon Comment Letter to SEC

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

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

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

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

NFA to Require Disclosure of Digital Asset Activities

CPOs and CTAs to Augment Disclosure Documents

On July 20, 2018, the National Futures Association (“NFA”) submitted an Interpretive Notice titled Disclosure Requirements for NFA Members Engaging in Virtual Currency Activities to the Commodity Futures Trading Commission (“CFTC”).  Through Section 17(j) of the Commodity Exchange Ac (“CEA”), the NFA has invoked the “ten-day” provision to allow the Interpretive Notice to become effective 10 days after its submission to the CFTC.  The NFA has proposed this Interpretive Notice in an effort to better inform and notify consumers of the risks involved with trading and investing in cryptocurrencies.  This Interpretive Notice sets forth disclosure requirements for two groups: (1) futures commission merchants (“FCMs”) and introducing brokers (“IBs”) and (2) commodity pool operators (“CPOs”) and commodity trading advisors (“CTAs”).

Proposed Interpretive Notice

The proposed Interpretive Notice specifies the following requirements:

For FCMs and IBs:

  • provide customers with the NFA Investor Advisory – Futures on Virtual Currencies Including Bitcoin and the CFTC Customer Advisory: Understand the Risk of Virtual Currency Trading (collectively, the “Advisories”) and for introduced accounts, the FCM or IB may provide the Advisories;
  • provide customers who traded a virtual currency derivative prior to the issuance of the Interpretive Notice with the Advisories within 30 calendar days of the Interpretive Notice’s effective date;
  • provide customers of FCMs and IBs offering services in spot market virtual currencies with a standardized disclosure[1] that specifically states that the NFA does not have regulatory oversight authority over underlying or spot virtual currency products or transactions or virtual currency exchanges, custodians, or markets;
  • provide the Advisories to a customer at or before the time the customer engages in a virtual currency derivative transaction;
  • provide the standardized disclosure at or before the time a customer or counterparty engages in any underlying or spot virtual currency activity with or through the FCM or IB;
  • provide retail customers the Advisories and standardized disclosure language in writing or electronically in a prominent manner designed to ensure that the customer is aware of them; and
  • display the standardized disclosure language on any promotional materials related to spot market virtual currencies.

For CPOs and CTAs:

  • address the following areas that are applicable to their activities in their disclosure documents, offering documents, and promotional material related to virtual currencies: (1) unique features of virtual currencies; (2) price volatility; (3) valuation and liquidity; (4) cybersecurity; (5) the opaque spot market; (6) virtual currency exchanges, intermediaries, and custodians; (7) the regulatory landscape; (8) technology; and (9) transaction fees;
  • customize disclosure documents and offering documents to address all the unique risks related to their particular activities;
  • include a standardized disclosure[2] in disclosure documents, offering documents, and promotional materials related to virtual currencies addressing the limits of the NFA’s oversight and informing investors that there currently is no sound or acceptable practice that the NFA can use to verify the ownership and control of underlying or spot virtual currencies (this is a requirement of CPOs or CTAs that operate a pool, exempt pool, or trading program that trades spot market virtual currencies); and
  • provide a standardized disclosure[3] to customers and counterparties that specifically states that the NFA does not have regulatory oversight authority over underlying or spot virtual currency activities and display it in any promotional materials for any spot market virtual currency activities (other than as an investment in a pool or managed account program) engaged in by a CPO or CTA.

“Spot” Digital Assets vs. Digital Asset Derivatives

Throughout the proposed Interpretive Notice the NFA discusses both spot and derivative digital assets.  “Spot” digital assets are digital assets that are purchased for cash intended for immediate delivery and not at some future date.  The CFTC generally does not oversee spot digital assets, other than in instances of fraud or manipulation.  In contrast, digital asset derivatives are instruments that stem from and are priced in comparison to the underlying digital asset, with the underlying asset intended to be delivered at a future date.  Digital asset derivatives include instruments such as futures and options.  Unlike spot digital assets, the CFTC and NFA have jurisdiction over the digital asset derivatives.

What comes next?

Over the last few days our law firm has spoken with both the NFA and CFTC about this matter.  Although they could not provide more information regarding the drafting of the Interpretive Notice, they mentioned that once the Interpretive Notice becomes effective, individuals subject to the Interpretive Notice will be given time to become compliant.  They also mentioned that it likely that the NFA will issue another announcement that will publicize the effective date of the notice and when qualifying members need to be in compliance.

Conclusion

It is unclear if the CFTC will take up the NFA’s Interpretive Notice for approval or if the Interpretive Notice will become effective 10 days after its submission to the CFTC.  However, it should be noted that the majority of NFA proposals sent to the CFTC are approved.  Despite this, all FCMs, IBs, CPOs, and CTAs should review the various indicated communications and documents to prepare for the potential approval of the Interpretive Notice.  We will continue to report on this issue.

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Bart Mallon is a founding partner of Cole-Frieman & Mallon LLP.  Cole-Frieman & Mallon LLP has been instrumental in structuring the launches of some of the first digital currency-focused hedge funds and works routinely on matters affecting the digital asset industry.   Mr. Mallon can be reached directly at 415-868-5345

Links to the other NFA items on digital assets:

[1] The standardized disclosure required is the following: [NAME OF NFA MEMBER] IS A MEMBER OF NFA AND IS SUBJECT TO NFA’S REGULATORY OVERSIGHT AND EXAMINATIONS. HOWEVER, YOU SHOULD BE AWARE THAT NFA DOES NOT HAVE REGULATORY OVERSIGHT AUTHORITY OVER UNDERLYING OR SPOT VIRTUAL CURRENCY PRODUCTS OR TRANSACTIONS OR VIRTUAL CURRENCY EXCHANGES, CUSTODIANS OR MARKETS.

[2] The standardized disclosure required is the following: [NAME OF NFA MEMBER] IS A MEMBER OF NFA AND IS SUBJECT TO NFA’S REGULATORY OVERSIGHT AND EXAMINATIONS. [NAME OF NFA MEMBER] HAS ENGAGED OR MAY ENGAGE IN UNDERLYING OR SPOT VIRTUAL CURRENCY TRANSACTIONS IN A [COMMODITY POOL OR MANAGED ACCOUNT PROGRAM]. ALTHOUGH NFA HAS JURISDICTION OVER [NAME OF NFA MEMBER] AND ITS [COMMODITY POOL OR MANAGED ACCOUNT PROGRAM], YOU SHOULD BE AWARE THAT NFA DOES NOT HAVE REGULATORY OVERSIGHT AUTHORITY FOR UNDERLYING OR SPOT MARKET VIRTUAL CURRENCY PRODUCTS OR TRANSACTIONS OR VIRTUAL CURRENCY EXCHANGES, CUSTODIANS OR MARKETS. YOU SHOULD ALSO BE AWARE THAT GIVEN CERTAIN MATERIAL CHARACTERISTICS OF THESE PRODUCTS, INCLUDING LACK OF A CENTRALIZED PRICING SOURCE AND THE OPAQUE NATURE OF THE VIRTUAL CURRENCY MARKET, THERE CURRENTLY IS NO SOUND OR ACCEPTABLE PRACTICE FOR NFA TO ADEQUATELY VERIFY THE OWNERSHIP AND CONTROL OF A VIRTUAL CURRENCY OR THE VALUATION ATTRIBUTED TO A VIRTUAL CURRENCY BY [NAME OF NFA MEMBER].

[3] The standardized disclosure required is the following: [NAME OF NFA MEMBER] IS A MEMBER OF NFA AND IS SUBJECT TO NFA’S REGULATORY OVERSIGHT AND EXAMINATIONS. HOWEVER, YOU SHOULD BE AWARE THAT NFA DOES NOT HAVE REGULATORY OVERSIGHT AUTHORITY OVER UNDERLYING OR SPOT VIRTUAL CURRENCY PRODUCTS OR TRANSACTIONS OR VIRTUAL CURRENCY EXCHANGES, CUSTODIANS OR MARKETS.

Alternative Trading Systems (ATS)

ATS Registration Overview for Digital Asset Platforms

Digital asset platforms located in the U.S. that facilitate trading and exchange of digital assets (which are deemed to be securities) are generally subject to securities laws requiring such platforms to be registered as a national securities exchange (“NSE”) or fall within an exemption from NSE registration.  One exemption from registration as an NSE allows firms to conduct a platform business if such firm is registered as an alternative trading system (“ATS”).  This requirement was first highlighted by the SEC in the DAO Report released in July 2017.  We anticipate that many digital asset platforms currently facilitating trading will continue to face scrutiny as to whether they need to be registered as NSEs or an ATS and many have already begun the process to register as an ATS.

ATS Definition & Requirement to Register

The statutory definition of an ATS is:

any organization, association, person, group of persons, or system:

(1) That constitutes, maintains, or provides a market place or facilities for bringing together purchasers and sellers of securities or for otherwise performing with respect to securities the functions commonly performed by a stock exchange within the meaning of § 240.3b-16 of this chapter; and

(2) That does not:

(i) Set rules governing the conduct of subscribers other than the conduct of such subscribers’ trading on such organization, association, person, group of persons, or system; or

(ii) Discipline subscribers other than by exclusion from trading.

As many digital asset platforms or exchanges technically fall within the ATS definition, these platforms will need to appropriately register with the SEC.  To register as an ATS, the platform will need to do the following:

  1. Register as (or buy) a broker-dealer
  2. File Form ATS
  3. Comply with Regulation ATS

1. Register as a Broker-Dealer

Registering as a broker-dealer (“BD”) is a pre-requite to becoming an ATS.  A firm may only file Form ATS with the SEC after receiving the Financial Industry Regulatory Authority’s (“FINRA”) approval of its broker-dealer application (or after purchase of a broker-dealer).  For platforms registering as a broker-dealer, at a high level the firm must:

  • Submit Form BD;
  • Comply with all applicable state requirements; and
  • Ensure all of its “associates persons” (BD representatives) have satisfied applicable qualification requirements.

The process to register as a new BD is well worn and relatively straight forward.  Firms applying to register as a BD will need to submit online through Form BD online and then submit a New Membership Application (“NMA”) to FINRA.  The NMA requires the firm to describe their business and compliance policies and controls in detail.  A firm will also be subject to an in-person new membership interview and will have to demonstrate how the ATS technology operates to FINRA staff.  As part of the BD process, the firm will need to become a member of at least one self-regulatory organization (“SRO”), which is likely to be FINRA, and become a member of the Securities Investor Protection Corporation (“SIPC”).

If a firm is already a broker-dealer (or has a broker dealer affiliate) but is not an ATS, the firm will need to submit a Continuing Membership Application (“Form CMA”) to FINRA.  For groups registering as a de novo BD, the firm should describe those parts of its business that will include the ATS function.  As with a de novo BD, an existing BD must demonstrate to FINRA staff how the ATS technology operates.

 2. File Form ATS

After a firm has registered as a BD and has discussed the ATS platform with FINRA (to FINRA’s satisfaction), the firm will need to notify the SEC that it is operating as an ATS.  Form ATS is the official SEC notification and must be submitted at least 20 days before the firm begins to operate its platform.

Form ATS is general in scope and requires information such as:

  • Certain identification information (i.e. full name, business name, address, CRD number, etc.)
  • Firm incorporation documents as attachments
  • Description of the types of users on the platform (i.e., broker-dealer, institution, or retail) and any differences in access to services between such users
  • List of the types of securities (digital assets/tokens which are deemed to be securities) that will be traded on the platform
  • Description of how the ATS will operate
  • Description of certain ATS operational procedures (i.e., entry of orders, transaction executions, reporting transactions, compliance, etc.)

It is important to note that Form ATS is a notice filing where the SEC provides no confirmation to the ATS regarding the filing status unless the form is deficient.  When a Form ATS has been filed with the SEC, it will be listed on the SEC website which will display the platform’s full name, the name(s) under which business is conducted, and the city and state of the ATS.  The reports on Form ATS are generally not published and are considered confidential.  Such reports will only be available to the SEC staff, state securities authorities, and any SRO for examination.

3. Ongoing Compliance

An ATS will be subject to numerous compliance obligations outside.  Some of the specific ATS obligations include:

  • File Form ATS-R (which summarizes the ATS’s transactions, on a quarterly basis) within 30 calendar days after the end of each quarter.
  • Amend Form ATS at least 20 calendar days before implementing a material change to the operation of the ATS.
  • Update Form ATS within 30 calendar days after the end of each quarter to correct any inaccurate or unreported information.
  • Permit the examination and inspection of its premises, systems, and records and cooperate with the examination, inspection, or investigation of subscribers by the SEC or SRO of which such subscriber is a member.

Additional BD, FINRA, and other guidelines, regulations, and obligations include:

  • Participating in the lost and stolen securities program.
  • Complying with the fingerprinting requirement.
  • Maintaining and reporting information regarding affiliates.
  • Following certain guidelines when using electronic media to deliver information.
  • Maintaining an anti-money laundering program.
  • Complying with the Department of Treasury’s Office of Foreign Assets Control (“OFAC”) programs.
  • Filing quarterly and annual financial statements to the SEC.

If an ATS is not in compliance with the above requirements it may be subject to steep penalties.  In addition, it is important to note that securities on a registered ATS platform may be subject to a wide range of holding periods which must be enforced for an ATS to remain in compliance.

Registration Timing

It is unclear exactly how long a particular ATS application will take to be approved – it will largely depend on the exact scope of activities the platform will be involved with.  In general a platform designed for trading of private placements (in a kind of closed system for accredited investors) would likely take anywhere from 6-12 months to become fully licensed after submitting the Form NMA.  Technically, FINRA is required to review and process a substantially complete NMA within 180 calendar days after receiving it.

Issues to Consider

There are a number of issues to consider with respect to an ATS application.

  1. Underlying Instruments – the securities on most current digital asset exchanges are unregistered securities which were originally offered outside of any sort of registration exemption. Essentially these are restricted securities and any person selling or reselling such securities are arguably violating US securities laws (for more background, please see our post on restricted securities and distribution structures).  In such a case, we are not sure how FINRA will view a platform which facilitates the trading of restricted instruments.  We have seen many token issuers over the last 6-12 months who have decided to offer their tokens/securities according to registration exemptions, including through SAFTs.  To the extent a digital asset platform only transacts with such tokens (or tokens which go through the S-1 IPO process, which we think will happen within the next 12 months), we believe it is likely that such a platform would be able to be registered with FINRA.
  2. Discussion with FINRA Regarding Trading System – we have not talked directly with FINRA about their review of ATS platforms.  Most ATS platforms were created to allow for “dark pool” trading in the traditional institutional securities space.  It is unclear if FINRA has the experience or technical understanding (currently) to deal with digital assets and applicable trading platforms.
  3. IRS Reporting Requirements – the IRS released a notice in 2014 regarding the tax treatment of virtual currency. Since then, the IRS has subjected exchanges to certain user reporting requirements.  It is unclear whether the IRS will extend these types of user reporting requirements to ATS platforms as well.
  4. FinCEN’s Money Services Businesses Requirements – the Department of the Treasury’s Financial Crimes Enforcement Network (“FinCEN”) released guidance in March of 2013 regarding individuals who handle virtual currencies. FinCEN determined that a person engaged as a business in the exchange of virtual currency for real currency, funds, or other virtual currency (an “exchanger”) is subject to money services business (“MSB”) registration.  Although it is unclear if an ATS qualifies as a MSB, FinCEN has taken action against virtual currency exchanges that did not register with the bureau.
  5. Anti-Money Laundering and Know Your Customer Requirements – MSBs are required by the Bank Secrecy Act to have Anti-Money Laundering (“AML”) and Know Your Customer (“KYC”) procedures. AML procedures are required to detect and report suspicious actives that may indicate money laundering and terrorist financing.  KYC procedures are identification verification actions taken to ensure that the user is truly who they claim to be in order to prevent fraud.
  6. State Regulations – many states have imposed their own laws regarding digital assets. In addition, each state has its own rules and regulations regarding ATS platforms that operate within the state.  Before beginning to operate an ATS, you will want to research what rules and regulations your state has imposed.

Conclusion

After the DAO report, there have been a number of recent comments from SEC officials regarding digital assets and trading platforms that show the need for the cryptocurrency industry to quickly begin the process of integrating into the traditional securities regulatory landscape.  We believe that the ATS structure will become the predominant structure for digital asset exchanges in the future.  We also believe that over the next 12-24 months, as regulators flesh out various issues, the process will become more streamlined and well worn.  A few cryptocurrency related platforms have already started the process to become an ATS, with more likely to follow.

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Bart Mallon is a founding partner of Cole-Frieman & Mallon LLP.  Cole-Frieman & Mallon LLP has been instrumental in structuring the launches of some of the first digital currency-focused hedge funds and works routinely on matters affecting the digital asset industry.  Please contact Mr. Mallon directly at 415-868-5345 if you have any questions on this post.