Clients, Friends, Associates:

The first quarter of each year is typically a busy time for both investment managers and services providers.  The first quarter of 2019 was no exception.  Now that many of the filing deadlines have passed, and audit work should be completed (or nearly so), we enter the second quarter of 2019 with regulatory changes and developments on the horizon.  Below is a brief overview of some items that we hope will help you stay on top of the business and regulatory landscape in the coming months.

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SEC Matters

SEC Publishes Examination Priorities for 2019.  On December 20, 2018, the SEC announced its Examination Priorities for this year.  In 2019, the SEC intends to place emphasis on matters concerning digital assets, cybersecurity, and matters of importance to retail investors, including fees, expenses, and conflicts of interest.  Specifically, the SEC will focus on (i) compliance and risks in critical market infrastructure; (ii) retail investors, including seniors and those saving for retirement; (iii) FINRA and MSRB; (iv) cybersecurity; and (v) anti-money laundering programs.  We recommend speaking with your compliance firm to ensure your books and records as well as operations are in compliance with the securities rules.

SEC Adopts Final Rules Allowing Exchange Act Reporting Companies to Use Regulation A.  Regulation A provides an exemption from registration under the Securities Act for offerings of securities up to $50 million within a 12-month period.  On December 19, 2018, the SEC amended Regulation A to enable companies that are subject to the reporting requirements of Section 13 or 15(d) of the Securities Exchange to use Regulation A.  The amendments also permit such reporting companies to meet their Regulation A ongoing reporting obligations through their Securities Exchange Act reports.

SEC Proposes Rule Changes for Fund of Fund Arrangements.  On December 19, 2018, the SEC voted to propose a new rule and related amendments designed to streamline and enhance the regulatory framework for fund of fund arrangements.  The SEC’s proposal would allow a fund to acquire the shares of another fund in excess of the limits of Section 12(d)(1) of the Investment Company Act without obtaining an individual exemptive order from the SEC.  To rely on the rule, funds must comply with conditions designed to enhance investor protection, including conditions restricting the ability of funds to improperly influence other funds, charge excessive fees, or create overly complex fund of fund structures.

SEC Takes Action Against Robo-Advisers.  On December 21, 2018, the SEC settled proceedings against two robo-advisers for making false statements about investment products and publishing misleading advertising.  The proceedings were the SEC’s first enforcement actions against robo-advisers, which provide automated, software-based portfolio management services.

SEC Opens Registration in Compliance Outreach Seminar. The SEC will be sponsoring a seminar on May 16, 2019 as part of its compliance outreach program. The program seeks to aid chief compliance officers and other investment adviser or investment company personnel in the development of their compliance programs. The seminar will be held in Pittsburgh, Pennsylvania, and the topics include 2019 exam and enforcement priorities, common deficiencies, cybersecurity, and what to expect in an examination. Those interested in attending the seminar may register here.

CFTC Matters 

CFTC Releases a Primer about Smart Contracts. On December 11, 2018, LabCFTC, the CFTC’s hub for engagements with the FinTech innovation community, released a primer to help explain smart contract technology and related risks and challenges. The primer looks to provide a definition for smart contracts by looking at smart contract history, characteristics, and potential application in daily life.

NFA Adopts Proficiency Requirements for Swap-Related Associated Persons. On March 25, 2019, the NFA adopted an interpretive notice regarding its amendments to NFA Bylaw 301 and NFA Compliance Rule 2-24 which will implement changes to the NFA’s Swaps Proficiency Requirements. These new rules will go into effect on January 1, 2020 and will require all Associated Persons who engage in, or supervise activities involving, swaps at futures commission merchants, introducing brokers, commodity pool operators, commodity trading advisers, swap dealers, and major swap participants to take and pass a proficiency exam. The exam tests both market knowledge and knowledge of regulatory requirements, and there is no grandfathering provision within the new requirements. The new rules provide for two tracks of testing: the Long Track for swap dealers and the Short Track for all others. The NFA’s Swaps Proficiency Requirements must be completed by January 31, 2021.

NFA Amends its Interpretive Notice on Information Systems Security Programs. In March 2016, the NFA issued an interpretive notice requiring each member to adopt a written information systems security program (ISSP) to combat and effectively respond to unauthorized access of their information technology systems. On January 7, 2019, the NFA announced that it amended the notice to provide more clarification on ISSP approval and the corresponding training requirements for members. Additionally, the amended notice now requires NFA members (other than FCMs) to notify the NFA when certain cybersecurity incidents occur. The amendments to the March 2016 notice became effective April 1, 2019.

NFA Adopts Interpretive Notice Regarding CPO Internal Controls Systems. On April 1, 2019 the NFA adopted an interpretive notice applicable to CPO NFA members that have the ability to control customer funds. The notice specifically requires these CPO NFA members to implement an internal controls framework meant to protect customer funds and provide reasonable assurance that the CPO is in compliance with all CFTC and NFA rules, especially rules regarding maintenance of books and records for each commodity pool.

CFTC Announces 2019 Examination Priorities. On February 12, 2019, the CFTC announced its 2019 examination priorities–the first time the CFTC has done so in its history. In the announcement, the Division of Market Oversight (DMO), the Division of Swap Dealer and Intermediary Oversight, and the Division of Clearing and Risk each summarized their respective priorities. Of note, one of the DMO’s 2019 priorities include cryptocurrency surveillance practices.

Digital Asset Matters

SEC Commissioner Discusses Regulatory Considerations Concerning Digital Assets.  On February 8, 2019, SEC Commissioner Hester Peirce provided remarks concerning regulation and innovation.  Commissioner Peirce stated that digital asset tokens sold for use in a functioning network, rather than as investment contracts, fall outside the definition of securities.  Commissioner Peirce also acknowledged the uncertainty of the regulatory environment concerning digital assets as well as the novel challenges presented by digital asset trading platforms.  Additionally, Commissioner Peirce suggested that there will be further development of the digital asset regulatory environment in 2019.

SEC Issues a Public Statement on Digital Assets as Investment Contracts. On April 3, 2019, the SEC released a public statement discussing whether digital assets are considered securities by virtue of being offered and sold as investment contracts. The public statement references both a published framework of analysis by FinHub and a response to a no-action request by the Division of Corporation Finance. FinHub’s published framework identifies the relevant factors in determining whether a digital asset is offered or sold as an investment contract. Further, the no-action letter demonstrates the type of digital asset that the Division of Corporation Finance would not consider an investment contact or, accordingly, a security.

District Court Reconsiders Previous Ruling, Grants SEC Preliminary Injunction.  Last November, in what was seen as a victory for ICO issuers, a District Court denied the SEC’s attempt to obtain a preliminary injunction against a digital asset company, holding that the SEC failed to prove the company’s token was a security.  On February 14, 2019, the District Court reversed its position and granted a preliminary injunction to the SEC, holding that the contents of the company’s website, whitepaper, and social media posts concerning the company’s ICO constituted an offer of securities.

CFTC is Seeking Comments on Digital Asset Mechanics and Markets.  On December 11, 2018, the CFTC announced it is seeking public comment and feedback to better inform the CFTC’s understanding of the underlying technology, opportunities, risks, mechanics, use cases, and markets for virtual currencies beyond Bitcoin, namely Ether and its use on the Ethereum Network.  The CFTC is seeking to understand the similarities and distinctions between Ether and Bitcoin, as well as Ether-specific opportunities, challenges, and risks.

ICO Issuer Settles Unregistered ICO Charges After Self-Reporting to the SEC. On February 20, 2019, the SEC announced a settlement regarding an unregistered ICO by a company that raised over $12 million in digital assets in late 2017 to finance its operations. In the summer of 2018, the company self-reported to the SEC and cooperated with the SEC’s investigation. The SEC stated that it did not impose a penalty on the company because the company self-reported, agreed to compensate investors, and will register the tokens in compliance with securities laws.

Although the company conducted an ICO after the SEC released the DAO Report on July 25, 2017, the SEC’s decision to forgo fining the company suggests the SEC’s approach to the digital asset space is to focus on fraudulent conduct rather than stifling innovation in the space.

Nasdaq Offers Bitcoin and Ethereum Liquid Indices.  As of February 25, 2019, Nasdaq is offering spot Bitcoin and Ethereum indices, quoted in USD, based on real-time prices.  This move by Nasdaq, which lists over 3,300 companies and carries out approximately 1.8 billion trades per day, could serve as a step towards mainstream adoption of digital assets.

Florida Court Rules Direct Sales of Bitcoin Constituted Money Transmission.  On January 30, 2019, the Third District Court of Appeals in Florida held that an individual’s sale of Bitcoin for cash constituted money transmission and the sale of a payment instrument.  The Court held that since the seller was not licensed to act as a money services business, he could be charged with engaging in unlawful money transmitter services in connection with sales of Bitcoin for cash.

JPMorgan Creates Digital Asset Payment Coin.  On February 14, 2019, JPMorgan announced that it is the first U.S. bank to create and successfully test a digital coin representing a fiat currency, JPM Coin.  JPMorgan claims the JPM Coin will be used to make instantaneous payments using blockchain technology.  While JPMorgan claims that the JPM Coin is designed for institutional use and not for public investment, the company hopes to further develop JPM Coin’s utility in the future.

Other Matters 

FINRA Issues Panel Decision Regarding Transaction-Based Compensation. On January 29, 2019, FINRA’s Department of Enforcement released its decision in an enforcement hearing involving transaction-based compensation. In the decision, FINRA found that the respondent violated such  rules by paying compensation to (i) an unregistered finder’s non-member, unregistered entity and (ii) non-member, unregistered entities owned by its brokers. Additionally, FINRA held that the respondent failed to reasonably supervise its business and had inadequate written supervisory procedures that neither prevented nor detected deficiencies.

Atlanta Panel.  On April 24, 2019, Cole-Frieman & Mallon will be co-hosting a panel with Harneys and Trident Fund Services at Atlanta Tech Village.  The panel will cover developing topics in the investment management space including developments in the digital asset space, the rise of cannabis, and qualified opportunity zone funds.

Qualified Opportunity Zones.  This continues to be a hot topic:

Qualified Opportunity Fund Panel.  In February, Cole-Frieman & Mallon and Anderson Tax hosted a panel regarding qualified opportunity zone funds.  The panel addressed the tax and legal considerations that investment managers and investors should be aware of when creating or investing in a qualified opportunity zone fund.

IRS Holds a Public Hearing on Qualified Opportunity Funds.  On February 14, 2019, the IRS held a public hearing seeking input related to the first round of proposed rulemaking it issued in October 2018.  In the next round of proposed rules, the IRS is expected to provide (i) clarity on the definition of qualified opportunity zone business; (ii) data reporting requirements; (iii) clarity on interactions with other tax incentives; and (iv) guidance on interim gain reinvestment.  Further rule clarifications are expected in Spring 2019.

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Compliance Calendar.