Cole-Frieman & Mallon 2019 Second Quarter Update

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

Clients, Friends, Associates:

We hope you are enjoying the start of summer.  Typically the second quarter is quieter than the first quarter from a compliance perspective, however we continue to see meaningful enforcement actions taken by regulatory authorities and rapid developments in the digital asset space.  Entering the third quarter, we would like to highlight some items we hope will help you stay on top of the business and regulatory landscape in the coming months.

First, though, we’d like to announce a few exciting updates regarding Cole-Frieman & Mallon LLP. Scott E. Kitchens has joined the firm as a partner and will be leading the firm’s new Denver office.  Our firm is once again a founding sponsor of the quickly approaching CoinAlts Fund Symposium. The event will be held in Chicago on September 26th and the founding sponsors will be hosting a pre-conference cocktail hour in Chicago on July 18th.  We look forward to seeing many of you there.


SEC Matters

SEC Adopts New Regulation Best Interest.  On June 5, 2019, the SEC adopted a package of rules and interpretations to bring a new level of transparency between retail investors, investment advisers and broker-dealers, including the new Regulation Best Interest rule and the Form CRS Relationship Summary.  The new Regulation Best Interest requires broker-dealers to act in the “best interest of retail customers when making a recommendation,” whereas previously broker-dealers were only required to recommend “suitable” investments. Broker-dealers are also required to establish and enforce policies designed to comply with this rule.  The Form CRS Relationship Summary, which will become the new Form ADV Part 3, will require RIAs to provide retail investors with “easy-to-understand information about the nature of their relationship with their financial professional,” including information on services, fees, conflicts, their legal standard of conduct, and prior disciplinary history.  The Form CRS, will be a standardized question-and-answer format and must be presented to retail investors at the beginning of their relationship.  The rules are effective 60 days after their publication in the Federal Register, however broker-dealers and investment advisers are given until June 30, 2020 to ensure compliance.

Individual Liable Under Rule 10b-5 for Knowingly Disseminating False or Misleading Statements Made by Another Person.  On March 27, 2019, the Supreme Court ruled that an individual violated Rule 10b-5 by disseminating statements he knew to be false to potential investors, even though he didn’t “make” the statements himself.  The individual sent an email to potential investors stating the assets of a company seeking investment was $10 million at the direction of his boss, who supplied the content and approved the email, while the individual knew the total assets were worth less than $400,000.  The case may result in an expansion of personal liability for those who transmit false or misleading statements that were made by another.  Managers should ensure that their supervised persons are not repeating false statements even if those statements were made by a superior.

SEC’s Office of Compliance Inspections and Examinations (“OCIE”) Issues Risk Alert.  On May 23, 2019, the OCIE issued a risk alert regarding the safeguarding of customer records and information network storage.  The OCIE observed that many firms did not always use their storage solution’s security features to prevent unauthorized access, including failing to use encryption or password protection.  The OCIE identified the following concerns that may give rise to compliance issues: (i) misconfigured network storage solutions; (ii) inadequate oversight of vendor-provided network storage solutions; and (iii) insufficient data classification policies and procedures. The OCIE encourages registered broker-dealers and investment advisers to evaluate their storage of customer information and consider whether security improvements are necessary.

RIA Settles with SEC for $5 Million for Failing to Implement Compliance Policies Reasonably Designed to Prevent Inaccurate Valuations.  On June 4, 2019, the SEC settled charges and instituted cease-and-desist proceedings against an RIA for failing to adopt compliance policies reasonably designed to prevent the risk that its traders were undervaluing securities by failing to maximize relevant observable inputs, such as trade prices. The RIA’s traders were accused of intentionally marking their bond prices below market value to maximize yield and allow them to sell for a profit when needed, in violation of GAAP.  While the RIA did not admit fault, the SEC alleged that the firm’s policies failed to address how their valuations would be conformed with GAAP, and further, that the adviser failed to implement its existing policy.  The SEC stressed the importance of valuation of client assets in the administrative proceeding, calling it “critically important.”

SEC Imposes Cease-And-Desist Order and Remedial Sanctions Against an RIA for “Cherry-Picking” Trades and Misusing Soft-Dollars.  On May 16, 2019, the SEC imposed a cease-and-desist order and remedial sanctions against an RIA for “cherry-picking” trades and misusing soft-dollars.  The RIA disproportionally allocated profitable trades to hedge funds of which the RIA’s portfolio manager was personally invested, while allocating less profitable trades to other clients, including a charitable foundation.  Further, the RIA allegedly used soft-dollar credits in a manner not disclosed to clients, including use in a principal’s divorce settlement, rent paid to a principal owned company, and maintenance fees on a principal’s personal timeshare.  In addition to disgorgement for both the RIA and portfolio manager, the portfolio manager has been banned from the industry.  This case is a reminder for investment advisers to only use soft-dollar credit to pay for disclosed expenses.

SEC Charges RIA Firm and COO for Cross Trades that Defrauded Client.  On March 15, 2019, the SEC charged a fund manager (an RIA) and its chief operating officer with breaching its fiduciary duties, including the obligation to seek the maximum price for an asset to be sold.  The RIA solicited two unwilling buyers to participate in a real estate auction under the promise that they would not win in order to artificially depress the price and allow a second private fund managed by the RIA to purchase it at a discount.  The RIA later resold the asset from the second private fund for a significant profit and received associated performance fees.  With the SEC’s continued focus on cross trades, fund managers should ensure their cross trade policies effectively identify and manage conflicts of interest.

SEC Proposals to Address Cross-Border Application of Security-Based Swap Requirements.  On May 10, 2019, the SEC proposed a series of rule amendments and guidance with the intention of improving the regulatory framework governing cross-border security-based swaps.  The proposals address the application of security-based swap transaction requirements to non-U.S. entities with U.S. personnel involved in “arranging, negotiating or executing the swaps,” and is intended to align the SEC’s regulatory regime with that of the Commodity Futures Trading Commission.  The SEC sought public comment on the proposed amendments and guidance, with comments due July 2, 2019.

CFTC Matters 

CFTC Approves Final Rule to Provide Exception to Annual Privacy Notice Requirement.  On April 25, 2019, the CFTC approved a final rule to remove the requirement that commodity pool operators and commodity trading advisers, among others, provide annual privacy policy notices to customers when certain conditions are met.  The new rule provides an exception to such annual notice when a financial institution (i) does not share nonpublic personal information except in accordance with certain exceptions adopted by the CFTC and (ii) has not changed its policies and practices with regard to disclosing nonpublic personal information from those policies and practices that the institution most recently disclosed.

CFTC Publishes Public Enforcement Manual.  On May 8, 2019, the CFTC’s Division of Enforcement published its Enforcement Manual for the first time, providing clarity on the CFTC’s investigations and pursuit of violations processes.  In addition to increasing predictability of CFTC enforcement actions, the guide underscores the CFTC’s intention to incentivize self-reporting and cooperation, noting that the value of cooperation with the CFTC will be considered in deciding what charges and sanctions to impose and whether an individual or entity is eligible for a non-prosecution agreement or deferred prosecution agreement. The manual also provides a summary of prohibited conduct subject to investigation, which in addition to traditional enforcement action such as fraud, includes misappropriation of material non-public information and disruptive trading practices. The Enforcement Manual promises to provide meaningful information to advisers who suspect they may have committed a violation.

FINRA Matters 

FINRA Begins Effort to Simplify Firms’ Digital Experience.  On May 14, 2019, FINRA announced the launching of its Digital Experience Transformation, with the goal of simplifying digital interactions between firms and FINRA to create more efficient and effective compliance programs. The transformation is set to be implemented in stages through 2022, focusing on six solution areas identified as priorities by FINRA member firms, including enhanced interaction with FINRA staff and a simplified experience for users.

FINRA Introduces Peer-2-Peer Compliance Library.  FINRA launched its Peer-2-Peer Compliance Library providing a resource for member firms in locating templates, checklists and other materials to supplement FINRA provided materials. The library includes documents provided by FINRA registered firms on six compliance topics: (i) Customer Information, (ii) Cybersecurity, (iii) New Product Review, (iv) Outside Business Activities, (v) Outsourcing & Vendor Management, and (vi) Supervision.  The Library promises to be a useful resource for FINRA registered firms.

Digital Asset Matters

SEC Delays Decision on Two Bitcoin ETFs.  On May 14 and May 20, 2019, the SEC again delayed a decision on two bitcoin ETFs.  The SEC has yet to approve a bitcoin ETF, and is again seeking public comment on the ETF proposals.  The SEC will ultimately need to make a final decision by mid-October.  Cole-Frieman & Mallon LLP submitted a comment in support of approval, arguing it is in the best interest of the bitcoin market that the ETF be approved as it will allow the continued expansion of the digital asset industry and the related ecosystems.

SEC Publishes First Framework in Determining if an ICO Constitutes a Security.  On April 3, 2019, the SEC published its first framework for analyzing whether U.S. securities laws apply to an initial coin offering.  The SEC has confirmed their view that the Howey test should be used to determine if an “investment contract” exists with respect to the sale of a digital asset, thus requiring the sale to either be registered or qualify for an exemption from registration.  The framework gives insight on each of the prongs of the Howey test, which states that an “investment contract exists when there is an investment of money in a common enterprise with a reasonable expectation of profits to be derived from the efforts of others.”  The framework gives examples of several characteristics that are indicative of an investment contract, which promises to provide helpful guidance for those seeking to raise funds through an initial coin offering.

SEC Publishes First No-Action Letter for Cryptocurrency Token Sale. On April 3, 2019, the SEC published the first no-action letter for the offer and sale of tokens by a jet leasing business.  The SEC stated that their no-action position was based on (i) the tokens being fully operational at the time of sale, (ii) the business selling the tokens for $1 each and redeeming each token for $1 of air charter services per token with the business only repurchasing tokens at a discount to face value, and (iii) the restriction on transfer of the tokens to external wallets.  Taken together, the SEC appears to have been satisfied that any purchase of the token would not be for investment purposes.

SEC Sues Online Messaging Application for Conducting $100 Million Unregistered Securities Offering of Digital Tokens.  On June 4, 2019, the SEC sued a Canadian company running a messaging app with conducting an illegal securities offering for raising over $100 million through an initial coin offering without registering the offer and sale as required under securities law.  The complaint alleges that the company advertised the tokens as an investment opportunity and promised to work to promote demand of the token through company efforts, including incorporating the tokens on their messaging app. This case underscores the importance of complying with securities laws when attempting to raise money through coin offerings, as the SEC will seek to enforce such laws if they deem the ICO a securities offering.

IRS Commissioner Announces Cryptocurrency Tax Guidance to be Released Soon.  On May 30, 2019, IRS Commissioner Charles Rettig stated in a letter to congressman Tom Emmer that cryptocurrency tax guidance is a priority of the IRS and should be released “soon.” The Commissioner stated that the IRS is considering several issues, including: (i) acceptable methods for calculating cost basis; (ii) acceptable methods of cost basis assignment; and (iii) tax treatment of forks.  Guidance promises to be welcome by crypto investors as the IRS last issued guidance in 2014, which left several key questions unanswered.  The cryptocurrency market has also seen itself become increasingly complicated since that time with the emergence of forks, airdrops and staking.

SEC Hosts Public Forum to Discuss Distributed Ledger Technology and Digital Assets.  The SEC held a public forum to discuss digital assets on May 31, 2019.  As the second forum on digital assets held by the SEC, it aimed to facilitate greater communication on digital assets between industry, academia, and regulators.  SEC staff moderated panels with fintech insiders covering capital formations, trading and markets, investment management, and distributed ledger technology industry trends.  The SEC also announced at the forum a new program for visiting scholars, seeking qualified professors or PhDs with expertise in blockchain to assists the SEC for one year with their oversight and regulatory processes.  The forum is available to view online.

FinCEN Takes First Enforcement Action Against a Virtual Currency Exchanger.  On April 18, 2019, the Financial Crimes Enforcement Network (“FinCEN”) assessed a $35,350 penalty against a peer-to-peer exchanger of bitcoin for the willful violation of the Bank Secrecy Act’s registration and reporting requirements.  FinCEN found the exchanger was not merely a “user” of virtual currency, but a “money transmitter,” and thus was required to register as a money services business and comply with regulatory requirements applicable to them, including having an effective written AML program, filing SARs on transactions they “know, suspect, or have reason to suspect” are suspicious, and filing currency transaction reports on transactions over $10,000.  Exchangers of virtual currency must be aware they are considered money transmitters and must comply with the Bank Secrecy Act’s regulations or risk monetary penalties and a ban from the industry by FinCEN.  FinCEN has indicated that they will continue to seek enforcement action against exchangers who fail to register as money services businesses.

CFM Summarizes Blockstack Regulation A+ Offering.  We have provided a summary of Blockstack’s Regulation A+ “Tier 2” offering to the SEC.  While Regulation A+ has previously been discussed as a potential avenue for blockchain groups to raise capital, it had been untested until now.  The post summarizes many of the legal and regulatory aspects of Blockstack’s offering, and also highlights interesting business aspects that were revealed.  As Blockstack’s offering was just “qualified” by the SEC, their offering circular promises to work as a guide for future blockchain token projects seeking to raise capital through Regulation A+.

Offshore Matters 

Cayman Islands Announce No Penalties for Delayed Filings.  On April 9, 2019, Cayman Islands announced that while the deadline for Cayman Financial Institutions’ to satisfy their CRS/FATCA reporting obligations was May 31, 2019.  Financial Institutions that report by July 31, 2019 will not be subject to enforcement measures or penalties.

Bermuda Proposes Legislation Exempting Non-Tax Residents from Economic Substance Requirements.  On June 28, 2019, Bermuda’s Economic Substance Amendment Act 2019 became law.  The Amendment creates an exemption from Economic Substance requirements for ‘non-resident entities,’ which is an entity which is a resident for tax purposes in a jurisdiction outside Bermuda, not including those countries in Annex 1 to the EU list of non-cooperative jurisdiction (the so called “black list”).  The change brings Bermuda’s regulations in line with the regulations of the British Virgin Islands and the Cayman Islands, both of which exclude non-resident entities from their substance requirements.

Other Matters 

IRS Issues Qualified Opportunity Fund Guidance.  On April 17, 2019, the IRS issued additional guidance for the deferral of capital gains through investment in qualified opportunity funds.  Crucially, the IRS clarified the “substantially all” requirement for the holding period and use of tangible business property.  Under the regulations, property can qualify as “qualified opportunity zone business property” if substantially all of the use of the property is in a qualified opportunity zone for substantially all of the qualified opportunity fund’s holding period of such property.  The IRS has clarified that the threshold for “substantially all” is (i) 70% with respect to the use of the property; and (ii) 90% with respect to the qualified opportunity fund’s holding period of such property.

IRS Issues Proposed Regulations for Determining Global Intangible Low-Taxed Income.  On  June 14, 2019, the IRS published proposed regulations that provide taxpayers with guidance for determining the amount of global intangible low-taxed income (“GILTI”) to include in gross income.  Importantly for fund managers, the proposed regulations change how the GILTI regime applies to domestic partnerships, adopting an aggregate approach where GILTI is computed at the partner level rather than the entity level.  As the regulations are retroactive to 2018, fund managers who paid GILTI should discuss with their tax advisers if filing an amended tax return is advisable.

Legislature Presented with Two Bills Reforming Cannabis Banking.  Two bills are being considered by Congress that attempt to provide cannabis-related businesses and service providers with access to the banking and financial markets. On March 28, 2019, the House of Representatives Financial Services Committee approved the Secure and Fair Enforcement Banking Act (“SAFE Act”), which would prohibit federal banking and financial regulators and law enforcement from taking action against institutions solely because they provide financial services to cannabis-related businesses and also excludes legitimate cannabis related business from being deemed proceeds from unlawful activity under anti-money laundering laws. On April 4, 2019, the Strengthening the Tenth Amendment Through Entrusting States Act (“STATES Act”) was re-introduced in both the House and the Senate.  The STATES Act would remove state-legal marijuana-related activity from the Controlled Substances Act, significantly restricting federal enforcement abilities of cannabis.  Both bills would significantly alter the cannabis industry, allowing them to access and interact with the economy in ways previously denied to them.


Compliance Calendar.


Please note the following important dates as you plan your regulatory compliance timeline for the coming months:

Deadline Filing
June 29, 2019 Delivery of audited financial statements to investors (private fund managers to fund of funds, including SEC, State, and CFTC registrants)
June 30, 2019 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 Cayman Islands Monetary Authority
June 30, 2019 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 31)
June 30, 2019 Review holdings to determine Form PF filing requirements
July 10, 2019 Review transactions and assess whether Form 13H needs to be amended
July 15, 2019 Quarterly Form PF due for large liquidity fund advisers
July 30, 2019 Quarterly account statements due (Commodity Pool Operators (“CPOs”) claiming the 4.7 exemption)
July 31, 2019 Cayman Islands CRS and US FATCA reporting deadline without adverse consequences (for those who missed the initial May 31, 2018 deadline)
August 14, 2019 Form 13F filing (advisers managing $100 million in 13F Securities)
August 14, 2019 CTA-PR filing with NFA
August 29, 2019 Quarterly Form PF due for large hedge fund advisers
August 29, 2019 CPO-PQR filing with NFA
September 30, 2019 Review transactions and assess whether Form 13H needs to be amended
September 30, 2019 Deadline to designate a MLRO, DMLRO, and AMLCO for Cayman Islands AML compliance
October 15, 2019 Quarterly Form PF due for large liquidity fund advisers
October 15, 2019 Annual Foreign Bank and Financial Accounts Report deadline (for those who missed the April 17 deadline

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

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