Below is our quarterly newsletter. If you would like to be added to our distribution list, please contact us.
July 12, 2018
Clients, Friends, Associates:
We hope that you are enjoying the start of summer. Although the second quarter is typically not as busy as the first quarter from a regulatory or compliance perspective, we continue to see rapid developments in the digital asset space. As we move into the third quarter, we would like to provide a brief overview of some items we hope will help you stay abreast of these developments.
In addition to the discussion below, we would like to announce a couple of firm items:
CFM Atlanta. Our Atlanta office has just moved into new space in the heart of Buckhead. The new office address is 3348 Peachtree Road NE, Suite 1030, Atlanta, GA 30326.
CoinAlts Fund Symposium. In April founding sponsor Cole-Frieman & Mallon hosted its second full day Symposium attended by over 300 professionals, students, and investors in New York. Featuring twenty eight speakers, including key-notes, John Burbank of Passport Capital and Mark Yusko of Morgan Creek Capital Management, CoinAlts East presented a broad spectrum of content essential to managers and investors in the digital asset space. Our next CoinAlts Fund Symposium will take place in San Francisco on September 20, 2018. More details to follow.
Managers with EU resident investors, but no presence within in the EU may also be required to appoint an EU local representative unless they can demonstrate processing is “occasional”, does not include special categories of EU resident personal data, including criminal, on a large scale, and is unlikely to result in a risk to the rights and freedoms of natural persons. We believe most of our clients generally fall into this exclusion and will not need to appoint an EU representative, but it may be challenging at present to find EU counsel that will advise on this requirement in the absence of more guidance from EU regulators. For more information on GDPR, including compliance items for hedge fund managers, please see our earlier post.
Legal and Regulatory Developments
SEC Proposes Rules Regarding Form CRS, Form ADV, and Disclosures in Retail Communications. On April 18, 2018, the Securities and Exchange Commission (“SEC”) proposed new rules and amendments to certain rules and forms under the Investment Advisers Act of 1940, as amended (“Advisers Act”) and the Securities Exchange Act of 1934, as amended. One proposal would require both registered investment advisers and broker-dealers to provide a summary (“Form CRS”) disclosing the nature and details of their relationship to retail investors. Form CRS would be added as a section to Form ADV and would disclose: (i) the relationships and services the firms offer; (ii) the standard of conduct and fees and costs associated with the services; (iii) specified conflicts of interest; and (iv) reportable legal or disciplinary events on the firm’s part or its financial professionals.
The SEC also proposed two new rules to reduce investor confusion caused by communications with broker-dealers and investment advisers by placing additional requirements on retail investor communications. One rule would restrict broker-dealers’ use of the terms “adviser” and “advisor” when communicating with retail investors. The other rule would require broker-dealers and investment advisers to disclose their SEC registration status in retail investor communications. It would also require associated natural persons and supervised persons to disclose their relationships with broker-dealers or investment advisers in retail investor communications. Comments to the SEC are due on or before August 7, 2018.
SEC Proposes Interpretation of Standard of Conduct for Investment Advisers. On April 18, 2018, the SEC proposed an interpretation of the conduct standard for investment advisers under the Advisers Act and requested comment on its proposal. The SEC also seeks comment on the following proposed requirements for SEC registered investment advisers (“RIAs”): (i) federal licensing and continuing education; (ii) periodic account statements; and (iii) financial responsibility requirements similar to those required of broker-dealers. Comments to the SEC are due on or before August 7, 2018.
SEC Charges 13 Private Fund Advisers for Repeated Form PF Filing Failures. On June 1, 2018, the SEC announced settlements with 13 SEC RIAs for repeatedly failing to provide risk monitoring information. The SEC found that the advisers continually failed to file annual reports on Form PF. Section 204(b) of the Advisers Act requires large fund managers to report information such as assets under management, fund strategy, and fund performance on Form PF. The SEC uses these reports to inform their rulemaking process and to target examinations and enforcement investigations. The SEC found that each of the advisers violated the Form PF reporting requirements under the Advisers Act. Although the advisers did not admit or deny the SEC’s findings, they agreed to be censured, cease and desist, and to each pay a $75,000 civil penalty.
SEC Charges Hedge Fund Adviser with Deceiving Investors. On May 9, 2018, the SEC charged a hedge fund adviser and certain principals, including the CEO and a former portfolio manager, for fraudulently overvaluing its funds by hundreds of millions of dollars. Defendants are alleged to have placed trades in exchange for inflated broker-dealer quotes and applied “imputed” mid-point valuations in a manner that further inflated the value of securities. The SEC is seeking permanent injunctions, the return of illicit profits with interest, and civil penalties.
SEC Charges Hedge Fund Firm for Asset Mismarking and Insider Trading. The SEC announced on May 8, 2018 that a manager agreed to settle charges regarding insider trading and fraudulent overvaluation of certain assets held by its hedge funds. The SEC found that two of the portfolio managers overstated the values of their hedge funds’ securities. In a separate order, the SEC alleged that the CFO failed to supervise the two portfolio managers appropriately and respond to red flags regarding the mismarking. The SEC also found that the portfolio managers violated insider trading laws by trading pharmaceutical securities on confidential information obtained through a former U.S. Food and Drug Administration official.
Second Circuit Amends Martoma Decision. On June 25, 2018, the U.S. Court of Appeals for the Second Circuit amended its decision in United States v. Martoma to clarify tippee liability in insider trading cases. As we discussed in a previous Quarterly Update, the Second Circuit once again upheld a former portfolio manager’s 2014 conviction for insider trading. In its amended decision, the court confirmed that a “meaningfully close personal relationship” is not required for tippee liability in insider trading cases.
Digital Asset Matters
We see many thought-provoking items in the digital asset sector as the industry moves towards greater institutional infrastructure. After numerous public statements by SEC officials, token issuers understand that there are several compliant ways to raise capital through token offerings. One way is through Regulation A+, which has many advantages over other securities offering mechanisms. We are also seeing many groups use airdrops as a way to try to circumvent the private placement regulatory regime. One item to specifically note, is that privately placed tokens may have resale restrictions that could create issues for both the token issuers and token purchasers. We are also aware of several groups beginning the process of registering as alternative trading systems or otherwise becoming broker-dealers and/or qualified custodians.
Outside of these items, we have summarized some notable regulatory developments in the second quarter. For a complete review of these developments, please consult our Digital Asset Regulatory Items blog post.
CFTC Issues Advisory on Virtual Currency Derivatives. On May 21, 2018, the Commodity Futures Trading Commission (“CFTC”) Division of Market Oversight and the Division of Clearing and Risk issued an advisory regarding virtual currency derivative products. The CFTC outlined key expectations for exchanges and clearinghouses operating in the virtual currency derivatives space:
- Enhanced Market Surveillance – an adequate market surveillance program would include sharing information on the underlying spot markets, allowing the CFTC to access a broad range of exchange trade data (i.e., trader identity, volumes, times, prices, and quotes), and real-time monitoring of all trading activity to identify red flags.
- Close Coordination with the CFTC Surveillance Group – exchanges should engage in regular discussions with the CFTC on surveillance of virtual currency derivatives contracts and allow access to data on settlement processes referenced in such contracts.
- Large Trader Reporting – exchanges should set large trader reporting thresholds for any contract at five BTC (or equivalent) to increase their ability to focus on relevant market information.
- Outreach to Members and Market Participants – exchanges should obtain comments from stakeholders on listing issues beyond contract terms and conditions. Comments should include explanations of opposing views and the exchanges’ perspectives.
- Derivative Clearing Organization’s Risk Management – the CFTC requests information from derivative clearing organizations (“DCOs”) necessary to assess the suitability of proposed initial margin requirements. The CFTC may require DCOs to amend inadequate initial margins. They may also request information regarding the approval process of proposed contracts.
NASAA Combats ICO Fraud. On May 21, 2018, the North American Securities Administrators Association (“NASAA”) announced its involvement in “Operation Cryptosweep,” one of the largest coordinated enforcement efforts against fraudulent Initial Coin Offerings (“ICOs”), crypto-related products, and cryptocriminals. Operation Cryptosweep is a combined effort between NASAA’s members, spanning more than 40 jurisdictions in the United States and Canada. Since April 2018, the operation has produced almost 70 inquiries and investigations in addition to 35 pending or completed enforcement actions related to digital assets and ICOs, including multiple actions against private funds. According to NASAA President Joseph Borg, these recent actions are only the beginning of further enforcement against ICO fraud.
5th Circuit Issues Mandate on Fiduciary Rule. On June 21, 2018, the U.S. Court of Appeals for the Fifth Circuit issued a mandate regarding the Department of Labor’s (“DOL’s”) Fiduciary Rule (“Fiduciary Rule”) after months of uncertainty. The Fifth Circuit’s mandate effectuates its March 15 decision to vacate the Fiduciary Rule. Although the DOL’s Fiduciary Rule appears defeated, the court’s decision may prompt the SEC and other regulators to revisit their plans for fiduciary reform.
Section 3(c)(1) of the Investment Company Act Amended. President Trump authorized the Economic Growth, Regulatory Relief, and Consumer Protection Act (“Growth Act”) on May 24, 2018. A portion of the Growth Act amends Section 3(c)(1) of the Investment Company Act of 1940, as amended, by increasing the number of investors allowed in a qualifying venture capital fund from 100 to 250 investors. The Growth Act — which will take effect in late 2019 — defines a qualifying venture capital fund as one with less than $10 million “in aggregate capital contributions and uncalled committed capital.”
The CFTC and NASAA Sign Information Sharing Memorandum. The CFTC and NASAA signed a Memorandum of Understanding (“MOU”) regarding the sharing of non-public information on May 21, 2018. The MOU aims to forge a closer working relationship between the CFTC and individual state securities agencies— represented by the NASAA— to better enforce the U.S. Commodity Exchange Act of 1936, as amended (“CEA”) by promoting voluntary, inter-agency sharing of non-public information. NASAA President Joseph Borg believes the MOU could assist NASAA members in enforcing both securities and commodities law violations, particularly against schemes related to digital assets and other modern commodities.
NFA Develops Swaps Proficiency Program and Exam. The National Futures Association (“NFA”) announced on June 5, 2018 that its board approved the creation of an online proficiency requirements program and exam for all associated persons participating in swaps activities. The swaps proficiency program is part of the NFA’s mandate under the CEA, which requires the NFA to set training standards and proficiency testing for individuals and activities governed thereunder. The online program and exam are expected to launch in early 2020.
Cayman Islands Revises and Clarifies AML Regulations. As mentioned in previous updates, the Cayman Islands released the 2018 revisions to its Anti-Money Laundering (“AML”) regulations earlier this year. The following are some notable changes:
- Non-Cayman Islands Monetary Authority (“CIMA”) registered funds (i.e., 4(4) funds) will be subject to AML regulations;
- All investment funds (registered and unregistered) must designate natural persons to act as Anti-Money Laundering Compliance Officers (“AMLCOs”), Money Laundering Reporting Officers (“MLROs”), and Deputy Money Laundering Reporting Officers (“DMLROs”) by September 30, 2018 or, for funds registering after June 1, 2018, upon submission of the registration application; and
- All investment funds (registered and unregistered) will be subject to enhanced AML processes and procedures.
CIMA also released a notice on April 6, 2018 to clarify its guidance notes on the AML regulations.
The guidance clarified that a fund could designate the same individual to serve as its AMLCO and MLRO. Also, if an MLRO, DMLRO, and AMLCO have been appointed, a person carrying out the relevant financial business of a fund may delegate to another the performance of functions outlined in the AML regulations. Significantly, managers should also note that these officers may be exposed to criminal sanctions for breach of their obligations. Failure to comply with CIMA’s AML regulations could result in an unlimited fine and imprisonment for two years. We recommend that fund managers discuss AML compliance and implementation issues with offshore counsel and the fund’s administrator.
Cayman Islands Appeals Court Holds That a Liquidator May Not Adjust a Shareholder’s NAV. The Cayman Islands Court of Appeal held that an official liquidator of a fund could not change a contractually agreed upon net asset value (“NAV”), even if it were based upon fraudulent numbers. The judge agreed with the lower court that allowing adjustment of the NAV would “interfere with the shareholders’ proprietary rights,” an action that legislators did not intend to permit. This outcome may benefit shareholders by providing certainty regarding a fund’s NAV and the benefits derived from “their rights under a valid and subsisting contract.”
Cayman Issues AEOI Portal Update. On May 29, 2018, the Cayman Islands issued an update regarding the Automatic Exchange of Financial Account Information Portal (“AEOI”). The statutory deadline for filing Common Reporting Standard (“CRS”) and US Foreign Account Tax Compliance Act, as amended, (“FATCA”) reporting was May 31, 2018. However, the Cayman Islands Department for International Tax Cooperation will allow Cayman Financial Institutions until July 31, 2018 to fulfill their 2017 CRS and US FATCA reporting obligations without facing adverse consequences, compliance measures, or penalties.
Compliance Calendar. As you plan your regulatory compliance timeline for the coming months, please keep the following dates in mind:
Deadline – Filing
- June 29, 2018 – Delivery of audited financial statements to investors (private fund managers to fund of funds, including SEC, state, and CFTC registrants)
- June 30, 2018 – Deadline for Cayman Island registered funds with a fiscal year end of December 31 to file the Fund Annual Return and audited financial statements with CIMA
- June 30, 2018 – Deadline for making available AIFMD annual report for funds in or advertising in the EU (Alternative Investment Funds with a financial year ending on December 31st)
- June 30, 2018 – Review transactions and assess whether Form 13H needs to be amended
- July 15, 2018 – Quarterly Form PF due for large liquidity fund advisers
- July 30, 2018 – Quarterly account statements due (CPOs claiming the 4.7 exemption)
- July 30, 2018 – Collect quarterly reports from access persons for their personal
- July 31, 2018 – Cayman Islands CRS and US FATCA reporting deadline without adverse consequences (for those who missed the initial May 31, 2018 deadline)
- August 14, 2018 – Form 13F filing (advisers managing $100 million in 13F Securities)
- August 14, 2018 – CTA-PR filing with NFA
- August 29, 2018 – Quarterly Form PF due for large hedge fund advisers
- August 29, 2018 – CPO-PQR filing with NFA
- September 30, 2018 – Review transactions and assess whether Form 13H needs to amended
- September 30, 2018 – Deadline to designate an MLRO, DMLRO, and AMLCO for Cayman Islands AML compliance
- October 15, 2018 – Quarterly Form PF due for large liquidity fund advisers
- October 15, 2018 – Annual Foreign Bank and Financial Accounts Report deadline (for those who missed the April 17 deadline)
- Periodic – Fund managers should perform “Bad Actor” certifications annually
- Periodic – Amendment due on or before anniversary date of prior Form D filing(s), or for material changes
- Periodic – CPO/CTA Annual Questionnaires must be submitted annually, and promptly upon material information changes
- Periodic – Form D and blue sky filings should be current
Bart Mallon is a founding partner of Cole-Frieman & Mallon LLP. Mr. Mallon can be reached directly at 415-868-5345.