Category Archives: Cryptocurrency Law & Regulation

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.

****

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

****

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!

****

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

****

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!

****

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.

****

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

****

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.

Aspect Advisors & CFM Compliance Update – January 23, 2020

IA / BD 2020 Compliance Overview & Networking Event

We would like to take this opportunity to introduce you to Aspect Advisors, a firm that focuses on regulatory compliance services for investment managers.  Aspect started at the beginning of 2019 and brings compliance solutions to broker-dealers, fintech companies, and traditional investment managers (hedge, PE, VC, real estate).  In conjunction with Justin Schleifer (President and Co-Founder of Aspect), we’d like to invite you to a compliance update presentation and networking event at the offices of Cole-Frieman & Mallon LLP on January 23rd.  The event will address the following topics:

  • 2020 compliance calendar (including Form ADV annual update)
  • Major issues from the SEC and courts in 2019
  • SEC focus on crypto / digital assets in 2020
  • Fintech regulations and best practices
  • Regulation Best Interest
  • Other hot topics

We are planning an engaging event with audience participation and discussion so come ready with questions!  If you are interested in joining, please review the information below and contact us for more information.

Best regards,
Bart

 

****

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.

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.

****

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).

****

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.

****

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.

****

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.

Crypto Headlines from Week of April 26 – Bitfinex/Tether & SeedInvest

There were two big announcements in the crypto space this week and we anticipate that both will shape the dialogue in crypto circles over the course of the next few months.

NY AG Order re Bitfinex and Tether – the New York Attorney General announced an order requiring Bitfinex to provide certain information on its corporate activities to New York in connection with an investigation into Tether.  The central issue is whether Bitfinex used Tether funds to “hide the apparent loss of $850 million dollars of [Bitfinex] co-mingled client and corporate funds.”  The order was announced yesterday and sent the entire crypto market down 10%.  Bitfinex has released a statement in response to the order saying that Bitfinex and Tether are “financially strong – full stop.”  We anticipate this will be a major story over the next couple of weeks.

SeedInvest Receives ATS License – ever since the SEC released the DAO report in July 2017, firms have been trying to secure a broker-dealer with an Alternative Trading System.  A broker-dealer with an ATS designation would allow a digital asset trading platform to legally provide an exchange/trading service in the US.  SeedInvest (which was recently bought by Circle), through its affiliated broker-dealer SI Securities, just received the ATS designation (see here on page 11 – “The Firm operates an alternative trading system to facilitate the trading of securities previously purchased in private placement transactions through SI Securities.”).  The ATS designation in this instance allows the firm to have a trading system/platform for previously issues equity securities (private placements) and not for tokens; however, it is generally viewed that this is the first step toward FINRA ultimately allowing for the ATS designation to apply to a token platform.  We will see how this plays out with other platforms in the near future but this is certainly a sign that regulators are moving in the right direction.

****

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.

Digital Asset Regulatory Items – Third Quarter 2018

The third quarter of 2018 saw increased interest from regulators in the digital asset space, as well as enforcement actions. For your convenience, we have provided an overview of key items from the quarter below.

***

SEC MATTERS

Enforcement

SEC Charges Digital Asset Hedge Fund Manager

On September 11, the Securities and Exchange Commission (“SEC”) announced the settlement of charges against a digital asset hedge fund and its manager. The charges included misleading investors, offering and selling unregistered securities, and failing to register the hedge fund as an investment company. The manager marketed the fund as the “first regulated crypto asset fund in the United States” and claimed the fund had filed registration statements with the SEC. Based on investments in “digital assets that were investment securities”, the fund was required to register as an investment company with the SEC. However, the fund was not registered and did not meet any exemptions or exclusions from the investment company registration requirements. The settlement included cease-and-desist orders, censure, investor rescission offers, and a $200,000 penalty. This is the first action the SEC has taken against a digital asset fund based on violations of the investment company registration requirements.

SEC Charges ICO Platform for Operating as Unregistered Broker-Dealer

On September 11, the SEC settled charges against an initial coin offering (“ICO”) platform. The business and its principals were charged with failing to register as broker-dealers and selling unregistered securities. This is the SEC’s first charge against an unregistered broker-dealer in the digital asset space following the SEC’s 2017 DAO Report, which cautioned anyone offering or selling digital assets to comply with federal securities laws such as broker-dealer registration requirements. The business agreed to pay $471,000 plus prejudgment interest, and the principals each agreed to a three-year bar from certain investment-related activities and $45,000 in penalties.

SEC Fines and Halts Fraudulent ICO

On August 14, the SEC settled charges related to an ICO. The token issuer was charged with fraud and the sale of unregistered securities after it claimed the proceeds from its ICO would be used to fund oil drilling in California. However, the issuer falsely represented that it had the necessary drilling lease and misled investors about the potential for profit and the prior bankruptcy and criminal history of the issuer’s principal. The settlement included permanent cease and desist orders, a permanent bar from certain investment-related activities, and a $30,000 fine. In light of recent charges like this, fund managers investing in ICOs should ensure they complete adequate due diligence on investment opportunities.

Other

SEC Denies and Delays Bitcoin ETFs

On August 22, the SEC released three separate orders denying nine Bitcoin exchange-traded fund (“ETF”) proposals. These orders followed the SEC’s July 26 denial of another Bitcoin ETF. The SEC’s reasoning in these denials was mainly based on a concern that the price of Bitcoin may be susceptible to manipulation. However, on September 20, the SEC announced that it has begun a formal review for a physically-backed Bitcoin ETF. The acceptance of such an ETF would increase digital asset investment options and has the potential to promote the overall growth of the industry.

SEC Suspends Trading of Swedish Bitcoin Instruments

On September 9, the SEC temporarily suspended trading of two foreign cryptocurrency investment instruments commonly known as the “Swedish Bitcoin ETFs”. The instruments hold Bitcoin on behalf of shareholders and, prior to the suspension, had been tradable in U.S. brokerage accounts. The SEC suspended the ETFs out of a concern for investor confusion, which was likely based on inconsistent representations. The issuers’ broker-dealer applications referred to the instruments as ETFs, other sources characterized them as exchange-traded notes, and the issuers’ offering memoranda described them as “non-equity linked certificates”. With this suspension in mind, fund managers considering investing in novel digital asset instruments should ensure they understand the nature of the instruments.

CFTC MATTERS

Investor Alerts

CFTC Stresses Due Diligence in ICO Investments

On July 16, the Commodities Futures Trading Commission (“CFTC”) published an alert cautioning investors to conduct extensive research before investing in any ICO, especially those that claim to be utility tokens (i.e. non-securities). The alert includes factors that investors should consider before investing in a token offering, such as the potential for forks, mining costs, liquidity, and risk of hacks.

Enforcement

Court Enters Final Order for CFTC Charges Against Crypto Company

On August 23, a New York federal court entered final judgment against a digital asset company based on charges brought by the CFTC. The company claimed that, in exchange for sending digital assets, customers could receive expert crypto trading advice or have the company trade on their behalf. However, no such expert advice or trading services were provided. The company was charged with fraud and the final judgment included a permanent injunction from certain investment-related activities, more than $290,000 in restitution, more than $871,000 in civil penalties, and post-judgment interest.

NFA MATTERS

NFA Requires CPOs and CTAs to Disclose Digital Asset Activity

On July 20, the National Futures Association (“NFA”) released a notice that imposed new disclosure requirements on futures commission merchants, commodity pool operators (“CPOs”), and commodity trading advisers (“CTAs”) engaged in digital asset activity. Specific to CPOs and CTAs, the NFA is now requiring discussion of certain aspects of digital asset investing, such as volatility, liquidity, and cybersecurity, as well as the inclusion of certain standardized disclosures. Additional details are available in our recent blog post.

FINRA MATTERS

FINRA Charges Broker with Fraud and Unlawful Distribution for Token Offering

On September 11, the Financial Industry Regulatory Authority (“FINRA”) charged a broker in connection with a token offering. The broker attempted to raise money through the offering for an allegedly worthless public company and, in the process, misled investors about the company’s operations and finances. The broker is charged with making material misrepresentations, offering and selling unregistered securities, and failing to notify the broker’s firm about the transactions. This is FINRA’s first disciplinary action involving digital assets.

FEDERAL LEGISLATION

Congressional Representative Introduces Crypto-Friendly Bills

On September 21, Minnesota Congressional Representative Tom Emmer announced three crypto-friendly bills. The first bill would codify an overall “light touch, consistent, and simple” approach to digital asset regulation. The second bill would provide a safe harbor for certain businesses that lack control over consumer funds by exempting them from certain regulations, such as money transmitter licensing requirements. Lastly, the third bill would limit fines for taxpayers that failed to fully report forked digital assets until the Internal Revenue Service (“IRS”) provides further guidance on how such forks should be reported.

STATE MATTERS

New York

New York Attorney General Releases Report on Digital Asset Exchanges

On September 18, the Office of the Attorney General of New York (the “OAG”) released a report summarizing a crypto exchange fact-finding initiative. The report outlines three primary areas of concern:

  • Conflicts of Interest – Crypto exchanges are exposed to potential conflicts of interest in several ways. For example, exchanges often have additional lines of business (e.g. broker-dealer) that would either be prohibited or carefully monitored in traditional securities contexts. Additionally, employees may have access to non-public information, and may hold and trade digital assets on their employer’s or competitors’ exchanges. Some exchanges also lack standards for determining which tokens are listed, and the possibility that an exchange may take fees for such a listing create a potential conflict of interest.
  • Lack of Anti-Abuse Efforts – Digital asset exchanges have not consistently implemented safeguards to protect the integrity of their platforms. Such safeguards include monitoring real-time and past trades, and restricting the use of bots. Additionally, some exchanges engage in proprietary trading (i.e. trading from the exchange’s own account in order to, for example, promote market liquidity) which may expose users to price manipulation or other abuse.
  • Limited Customer Funds Protections – Exchanges lack a consistent and transparent approach to auditing the digital assets they hold. Additionally, several exchanges do not have independent audits completed. These shortcomings make it difficult to determine whether crypto exchanges adequately maintain and protect customers’ assets. The OAG also raised concerns over whether exchanges have adequate protection against hacks and maintain sufficient insurance policies.

Digital asset fund managers should keep these concerns in mind and ensure they properly vet exchanges they may utilize.

Court Rules ICO Tokens May Be Subject to Securities Laws

On September 11, the U.S. District Court for the Eastern District of New York ruled that a criminal case brought against the individual behind two ICOs can proceed to trial. The defendant faces conspiracy and securities fraud charges for allegedly making false claims that the tokens sold in the ICOs were backed by real estate and diamonds. The defendant moved to dismiss the case on the grounds that securities laws are too vague to apply to ICOs, and that the issued tokens were not securities. The issue of whether the tokens in question are securities may now ultimately be decided by a jury.

Texas

Texas Issues Emergency Cease and Desists Against Crypto Investment Scheme

On September 18, the Securities Commissioner of Texas (the “Commissioner”) released three orders related to digital asset investment schemes. First, the Commissioner issued a cease and desist order against a mining company that used promotional materials falsely implying third-party endorsements and associations. Second, the Commissioner issued a cease and desist order against a company that solicited investments to develop a biometric token wallet. The business misled investors with a video of former President Barack Obama that falsely implied he was discussing the company. The business also made unsubstantiated claims, for example, that it was backed by “a leading financial institution”. Lastly, the Commissioner issued a cease and desist order against a company that solicited investments for its crypto and forex trading programs. The company told investors they could earn 10x returns, that those returns were guaranteed, and that there was no investment risk. All orders allege that the companies violated securities laws by offering and selling unregistered securities, engaging in fraud, and making materially misleading statements. These orders further highlight the need for fund managers to conduct due diligence on digital asset investment opportunities.

OTHER MATTERS

Statements

Congressional Representatives Urge IRS to Provide Guidance on Cryptocurrency

On September 19, five members of the House of Representatives published a letter urging the IRS to issue updated guidance on digital asset taxation. The last major guidance from the IRS, Notice 2014-21, was issued in March 2014. Since then, the IRS has increased digital asset scrutiny by, for example, requesting transaction records from crypto exchanges and choosing not to provide leniency through a voluntary crypto disclosure program. Such guidance would hopefully resolve some of the tax uncertainties digital asset fund managers currently face.

NASAA Announces Coordinated Digital Asset Investigations

On August 28, the North American Securities Administrators Association (“NASAA”) announced that regulators in the U.S. and Canada are engaged in more than 200 digital asset-related investigations as part of a coordinated NASAA initiative known as “Operation Cryptosweep”. While investigations have focused on suspected securities fraud, regulators have uncovered other violations, such as the offer and sale of unregistered securities. The initiative has resulted in at least 46 enforcement actions related to ICOs or digital asset investment products.

***

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