Cole-Frieman & Mallon 2018 First Quarter Update

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


April 5, 2018

Clients, Friends, Associates:

The first quarter of 2018 has seen many developments impacting traditional hedge fund managers as well as those in the digital asset space. We enter the second quarter with many topics worthy of discussion, including a number of important regulatory issues currently on the horizon.  Below, is our short overview of some of these items.

Before we begin though we’d like to quickly provide a couple of significant updates on Cole-Frieman & Mallon LLP. Effective January 1, 2018 we are delighted to announce that David C. Rothschild has been promoted to partner and welcome Kevin Cott as head of our Atlanta office following the merger of Cott Law Group, P.C. with our firm.


CoinAlts East

CFM is a founding sponsor of the one-day symposium for digital asset managers in New York on April 19, 2018. The CoinAlts East Fund Symposium will feature a number of panelists (including Bart Mallon and Karl Cole-Frieman) with expertise in the legal and operational aspects of running a digital asset strategy. Keynote speakers are John Burbank of Passport Capital and Mark Yusko of Morgan Creek Capital Management, with opening remarks from Corey Johnson of Ripple and closing remarks by Don Wilson of DRW. The inaugural symposium, held in September in San Francisco, sold out with more than 450 attendees.


SEC Matters

SEC Published Examination Priorities for 2018. The SEC announced its Examination Priorities for 2018, with a continued focus on examining matters of importance to retail investors, particularly risks to elderly and retiring investors. Specifically, the SEC will focus on: (i) disclosure and calculation of fees and other compensation, robo-advisers and other automated electronic investment advice platforms, never-examined investment advisers and exchange-traded funds, services offered to investors with retirement accounts, and regulatory compliance of advisers and broker-dealers in the cryptocurrency and initial coin offering (ICO) space; (ii) compliance and risk in critical market infrastructure, including clearing agencies, national securities exchanges, transfer agents, and Regulation Systems Compliance and Integrity (SCI) entities; (iii) FINRA and MSRB; (iii) cybersecurity; and (iv) anti-money laundering programs.

SEC Chairman Testifies on The Roles of the SEC and CFTC Concerning Virtual Currencies. On February 6, 2018, SEC Chairman Jay Clayton offered testimony to the Senate Committee on Banking, Housing, and Urban Affairs about the role of the SEC and CFTC in the regulation of cryptocurrencies, ICOs and related activities. Chairman Clayton expressed his support for new technological innovations in the financial markets, while emphasizing that these innovations should not be made at the expense of protecting investors and markets. The Chairman reaffirmed that whenever securities are bought and sold, investors are entitled to the protections and benefits of state and federal securities laws.

The Chairman also stressed that ICOs should be viewed in the context of securities laws and that many ICOs claiming to be “utility tokens” may be securities, notwithstanding labels or the provision of some utility. Further, the Chairman stated most ICOs to date that he has seen have been offers and sales of securities. As a sign of the SEC’s commitment to this policy, Clayton pointed to the establishment of a new cyber unit focused on misconduct involving ICOs and distributed ledger technology, and enforcement actions initiated against fraudulent ICOs.

SEC Staff Letter on Digital Asset Funds. On January 18, 2018, Dalia Blass, the Director of Investment Management at the SEC, published a staff letter addressing issues the SEC has identified for registered funds and products focused on cryptocurrency. While the letter does not address private funds, it outlines various questions addressing how cryptocurrency funds would satisfy the securities laws. The key concerns outlined in the letter include:

  • Uncertainty around valuation of cryptocurrencies;
  • Ensuring liquidity for fund investors;
  • Ability to satisfy custody requirements given the lack of qualified custodians;
  • Compliance by ETFs given market volatility; and
  • Potential manipulation of cryptocurrency markets.

In light of the questions and uncertainties identified, the letter expresses the belief that cryptocurrency funds should withdraw registration statements.

SEC Action against Initial Coin Offering. On January 30, 2018, the SEC obtained a court order for an immediate asset freeze to halt an allegedly fraudulent ICO targeting retail investors and claiming to be the world’s first “decentralized bank”. The complaint alleges among other violations, the ICO was an illegal offering of securities and the sponsors made multiple false and misleading statements, including that its customers could be covered under federal deposit protections due to its purchase of a bank. The SEC is seeking preliminary and permanent injunctions, disgorgement of ill-gotten gains plus interest and penalties, and bars against the two co-founders to prohibit them from serving as officers or directors of a public company or offering digital securities again in the future. This SEC complaint highlights the SEC’s increased vigilance in pursuing securities violations in the cryptocurrency and ICO space.

SEC Statement on Unregistered Digital Asset Exchanges. On March 7, 2018, the SEC released a public statement affirming its view that platforms that trade securities and operate as exchanges must register as a national securities exchange or operate under an exemption from registration. This announcement reflects the SEC’s growing interest in online virtual currency trading platforms. The public statement offers advice to investors about how to stay safe while investing on these platforms. Additionally, the statement lists considerations for market participants operating online trading platforms and encourages those market participants to consult with legal counsel and contact SEC staff for assistance in analyzing and applying the federal securities laws.

CFTC Matters

CFTC Issues Virtual Currency Pump-and-Dump Customer Protection Advisory. On February 15, 2018 the CFTC issued its first Customer Protection Advisory focused on virtual currency, specifically warning against “pump-and-dump” schemes. As described in the advisory, pump-and-dump schemes are coordinated online efforts to artificially drive up demand for a virtual currency then quickly sell. In the advisory, the CFTC asserted its general anti-fraud and manipulation enforcement authority over virtual currency cash markets as a commodity. The CFTC advises all customers to only purchase virtual currency or tokens after thorough research.

District Judge Agrees with CFTC Jurisdiction Over Virtual Currencies. On March 6, 2018, a district court judge in the eastern district of New York found that the CFTC has standing in a case related to virtual currency fraud. The judge agreed with the CFTC that virtual currencies can be regulated as a commodity, despite other regulatory agencies asserting jurisdiction over virtual currencies in some cases. The judge also agreed the CFTC’s jurisdiction can be justifiably expanded into spot trade commodity fraud, beyond the classic “futures” contracts for commodities traditionally focused on by the CFTC. The court granted the CFTC a preliminary injunction against the defendants as the case continues.

CFTC Launches Virtual Currency Resource Web Page. The CFTC launched its own resource dedicated to virtual currency, designed to provide information to the public regarding possible risks involved with investing or speculating in virtual currencies. It includes a primer on virtual currency, tips to avoid fraud, a podcast that includes CFTC staff discussing virtual currencies, and other reference sources relating to the CFTC and virtual currency.

FINRA Matters

FINRA Published Regulatory and Examination Priorities Letter for 2018. Similar to the SEC, the Financial Industry Regulatory Authority, Inc. (“FINRA”) recently published its 2018 Regulatory and Examination Priorities Letter, outlining the organization’s enforcement priorities for the current year. FINRA’s specific focus areas for 2018 will include: (i) fraud, particularly microcap fraud schemes that target senior investors; (ii) hiring and supervisory practices for high-risk firms and brokers; (iii) cybersecurity; (iv) anti-money laundering; (v) sales practices and product suitability for specific investors, including the supervisory, compliance, and operational infrastructure firms have put in place with respect to ICOs; and (vi) investor protections related to market manipulation. We recommend that you speak with your firm’s outside counsel and service providers to learn more about these specific priorities and review your firm’s compliance with the applicable regulations.

Other Digital Asset Matters

We have detailed some of the major digital asset regulatory releases for the first quarter of this year in a separate post.  In addition to this information, there are some other items of note below.

U.S. Deputy Secretary of Treasury Provides Testimony On Financial Threats. On January 17, 2018, the U.S. Deputy Secretary of Treasury, Sigal Mandelker, testified before the Senate Committee on Banking, Housing, and Urban Affairs regarding a litany of financial threats to national security as well as the U.S. and global financial systems. Among the threats mentioned were emerging technologies including virtual currency. Mandelker emphasized FinCEN’s global focus on ensuring virtual currency providers and exchangers improve compliance activities. Mandelker’s testimony further evidences governmental agencies’ increasing focus on virtual currencies.

Proposed Virtual Currency Regulations Introduced in Hawaii and Nebraska. Multiple bills proposing to regulate cryptocurrency have been introduced in Hawaii and Nebraska. In Hawaii, one  proposal defines virtual currency and exempts virtual currency money transmitters from the state requirement to possess reserves to cover all outstanding customer investments. A second  proposal in Hawaii requires certain persons engaging the exchange, transfer, or storage of virtual currency in the state to be licensed. The proposal also outlines various other requirements for such a licensee, including the requirement to provide extensive personal information. Additionally, proposals in Hawaii, Connecticut, and Nebraska have been introduced to adopt the Uniform Regulation of Virtual-Currency Businesses Act (URVCBA) developed by the Uniform Law Commission (ULC), which provides a three-tiered structure for registration and licensing.

In Wyoming, multiple bills were passed related to virtual currency. A law was passed that exempts virtual currency from the Wyoming Money Transmitter Act. The Wyoming legislature also passed a law that specifies criteria by which an issuer of virtual currency will not be deemed an issuer of a security in Wyoming. Another law was also passed in Wyoming that exempts virtual currency from Wyoming property tax.

President issues executive order on Venezuela’s Digital Currency. On March 19, 2018, the President of the United States issued an executive order prohibiting transactions by United States persons or within the United States related to any digital currency issued by the Venezuelan government on or after January 9, 2018. This order was made in response the Venezuelan’s government’s issuance of a digital currency in an attempt to avoid United States sanctions. The order also provides that no prior notice is necessary for this order given the ability to transfer assets instantaneously.

Other Items

Fifth Circuit Vacates DOL Fiduciary Rule. On March 15, 2018, the Fifth Circuit Court of Appeals  issued a judgment vacating the Department of Labor Fiduciary Rule in its entirety, which we  discussed in an earlier update. The Fiduciary Rule expanded the definition of a “fiduciary” to include anyone making a securities or investment property “recommendation” to an employee benefit plan or retirement account. The rule also included a Best Interest Contract (“BIC”) Exemption, which permits investment advisers to retail retirement investors to continue their current fee practices, including receiving variable compensation, without violating prohibited transactions rules, subject to certain safeguards. The Court vacated the rule, finding that the Department of Labor lacked the authority to enact the rule under ERISA. The Court stated, in part, that Congress did not intend to expand the definition of fiduciary in passing ERISA in 1974. Just days earlier, the Tenth Circuit upheld a portion of the Fiduciary Rule, opening up additional uncertainty about the rule and inviting the Supreme Court to provide clarification.

CIMA Releases Guidance Notes for changes to its AML regulations. The Cayman Islands Monetary Authority (CIMA) has released guidance notes on its 2017 revisions to its Anti-Money Laundering Regulations, which were discussed in our previous quarterly update. The new guidance, in part, provides details of the requirements when compliance under the revisions are outsourced or delegated. If you have any questions, we recommend that you reach out to your administrator or offshore counsel.

Supreme Court Narrows Dodd-Frank Whistleblower Protection. On February 21, 2018, in a unanimous decision, the Supreme Court of the United States held in Digital Realty Trust, Inc. v. Somers, that the anti-retaliation provision of the 2010 Dodd-Frank Act covers only individuals who have reported a violation of the securities laws to the SEC. The Dodd-Frank Act does not protect individuals who only report violations internally. This ruling does not affect the anti-retaliation provisions of the Sarbanes-Oxley Act which protects whistleblowers who report certain types of misconduct internally in public companies.

IRS Clarifies Carried Interest Taxation Regulation. On December 22, 2017, Congress passed the Tax Reform Act which, among other items, alters the taxation of carried interest. Under section 1061 of the Act, carried interest must be held for at least three years in order to recognize long-term capital gains on the distribution of that interest. Section 1061 provides an exception for partnership interests held by a corporation.

On March 1, 2018, the Internal Revenue Service and Department of the Treasury issued Notice 2018-18 announcing their intent to issue regulations providing guidance for section 1061 of the Internal Revenue Code. Specifically, the guidance would exclude “S corporations” from the definition of a “corporation” as applied to carried interest taxation. This guidance will be applied retroactively and is effective for taxable years beginning after December 31, 2017. Managers should discuss further implications with their tax advisor and legal counsel.

Supreme Court Narrows Scope of Bankruptcy Code Securities Clawback Safe Harbor. In a unanimous opinion, the United States Supreme Court narrowed the scope of transactions qualifying for protection under section 546(e) of the Bankruptcy Code. This provision generally provides an exception that disallows a bankruptcy trustee from recovering a settlement payment made by a financial institution in connection with a securities contract. The court’s ruling means that such exception will not apply when the financial institution acts only as an intermediary.

SEC Encourages Self-Reporting of Share Class Selection Disclosures. The SEC announced its Share Class Selection Disclosure Initiative (SCSD Initiative) which encourages investment advisers to self-report securities violations with respect to failure to make disclosures concerning mutual fund share class selection. Investment advisers are required to disclose the conflict of interest that arises when an adviser receives 12b-1 fees for a share class when a less expensive share class is available for the same fund. Generally, qualifying settlements with the SEC will require the adviser to return profits on the transaction to the harmed clients, but not impose any further monetary penalties. For those advisers that do not take advantage of the initiative, the SEC is still focused on violations associated with mutual fund share class selection.


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

Deadline – Filing

  • March 31, 2018 – Deadline to update and file Form ADV Parts 1, 2A & 2B
  • April 10, 2018 – Amendment to Form 13H due if necessary
  • April 16, 2018 – 1st Quarter 2018 Form PF filing for quarterly filers (Large Liquidity Fund Advisers)
  • April 30, 2018 – Collect quarterly reports from access persons for their personal securities transactions
  • April 30, 2018 – Distribute code of ethics and compliance manuals to employees. Require acknowledgement form to be executed in connection with such delivery
  • April 30, 2018 – Annual Privacy Notice sent to all clients or fund investors (for Advisers with Fiscal Year ending December 31)
  • April 30, 2018 – Distribute audited financial statements to investors (most private fund managers, including SEC, state and CFTC registrants)
  • April 30, 2018 – Distribute Form ADV Part 2 to clients
  • April 30, 2018 – Quarterly NAV Report (registered commodity pool operators claiming the 4.7 exemption)
  • April 30, 2018 – 2017 Annual Form PF due date for annual filers (Large Private Equity Fund Advisers and Smaller Private Fund Advisers)
  • May 15, 2018 – Quarterly Commodity Trading Advisor Form PR filing
  • May 15, 2018 – File Form 13F for first quarter 2018
  • May 31, 2018 – First deadline for Cayman Islands Financial Institutions to submit their CRS returns to the Cayman Islands Tax Authority
  • May 31, 2018 – Third reporting deadline (full reporting) for Cayman Islands Financial Institutions with reporting obligations under the Cayman FATCA regulatory framework to report their U.S. Reportable Accounts to the Cayman Islands Tax Authority
  • June 30, 2018 – Distribute audited financial statements to investors (private fund managers to funds of funds, including SEC, state and CFTC registrants)


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

Leave a Reply

This site uses Akismet to reduce spam. Learn how your comment data is processed.