July 21, 2022

Clients, Friends, Associates:

As we end the second quarter and enter the summer season, we would like to highlight some of the recent industry updates and occurrences we found to be interesting and impactful. While we try to keep these topics higher-level, please feel free to explore the links included and reach out to us if you have any related questions.

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CFM Items

We are pleased to announce the addition of Alex Yastremski to our firm as Partner to lead our Digital Asset Practice. We’d also like to highlight the addition of Frank J. Martin as Counsel and the promotion of Tony Wise to Partner. Additionally, we have hired Joe Burgess as Executive Director to continue our focus on operational excellence. Please join us in welcoming them all to our firm!

Our annual CoinAlts Fund Symposium is returning to San Francisco and will be held on November 3, 2022. Please mark the date on your calendar and stay tuned for further registration information. Attendance will be complimentary for clients of our firm and those of the other CoinAlts founding firms, MG Stover, Cohen & Company, and Harneys.

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SEC Matters

SEC Risk Alert on Material Non-Public Information Compliance Issues. The SEC recently released a risk alert summarizing the most common compliance deficiencies of both registered and unregistered investment advisers. Of note were (1) the lack of written policies to prevent the misuse of material non-public information (“MNPI”) and (2) the lack of compliance with the reporting requirements for “Access Persons” under the Code of Ethics Rule. All advisers should periodically revisit their written policies and procedures for the use of MNPI and registered investment advisers should review their Code of Ethics and establish reporting requirements for their Access Persons.

Enforcement Action for Misrepresenting Fees. The SEC instituted an enforcement action against a venture capital fund adviser and its CEO for misrepresenting their management fees as “industry standard 2 and 20” when they collected 10 years of management fees up front. This was misleading because it led investors to believe they would be charged an annual 2% management fee, rather than 20% of their total investment up front. The SEC also found that the adviser breached operating agreements by making inter-fund loans and cash transfers between funds. The adviser and its CEO agreed to a cease-and-desist order, returned funds, and paid penalties. In addition to confirming that the fund administrator reviews the offering documents and follows the mechanics for charging fees described therein, we recommend advisers closely review marketing materials with legal counsel or compliance consultants for any misleading or subjective statements.

OpenSea Insider Trading. A former high-ranking employee of OpenSea was recently indicted for wire fraud and money laundering in what the United States Attorney’s Office for the Southern District of New York characterized as the “first-ever digital asset insider trading scheme.” The former head of Product at OpenSea was in charge of selecting NFTs to feature on the website’s homepage and allegedly misappropriated that confidential information by purchasing those NFTs before they were promoted on OpenSea’s homepage.

While the alleged actions in the indictment are reminiscent of traditional insider trading under Section 10(b) of the Securities Exchange Act of 1934 (the “Exchange Act”), since NFTs are not yet categorized as securities under the Exchange Act, the prosecutors here wove allegations of traditional fraud and insider trading concepts into charges for wire fraud and money laundering. The prosecutorial creativity signals that despite lagging legislation, law enforcement is taking notice of the increasing fraudulent activity in the NFT space and is ready to tackle such unsavory business practices and provide greater consumer protection. While insider trading remains an unsettled area of law in the digital asset space, concepts of fraud are well established, malleable, and largely immune from claims that certain digital assets are not “securities.”

Adviser Liable for Late Audit Distribution. The SEC charged a registered investment adviser with Custody Rule and compliance violations for failing to complete an audit within 120 days of the private fund’s fiscal year end. The SEC found that the adviser failed to have required audits performed and failed to deliver audited financial statements to investors in certain funds from 2014 onward, and in certain other funds from 2018 onward. The adviser consented to a cease-and-desist order, a censure, a monetary penalty, and to provide a notice of the Order to past and current investors in the fund. This enforcement action serves as a reminder to all advisers to remain vigilant and stay on top of their auditors to complete and distribute the annual fund audit in a timely fashion.

SEC Doubles Size of Crypto Enforcement Unit. The SEC announced the allocation of 20 additional positions to a Crypto Assets and Cyber Unit (formerly the Cyber Unit) to protect investors in crypto markets from cyber-related threats. The expanded Crypto Assets and Cyber Unit will focus on investigating securities law violations related to crypto asset offerings, crypto asset exchanges, crypto asset lending and staking, decentralized finance, NFTs, and stablecoins. We think this is a step in the right direction; it is clear the SEC recognizes that the digital asset space is growing and that greater resources need to be brought to bear on the industry. 

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CFTC Items

Perpetual Futures and CFTC Regulation. Digital assets managers continue to inquire into the possibility of trading cryptocurrency futures contracts. With the Commodity Futures Trading Commission (“CFTC”) recognizing certain digital assets as commodities, proper registration with the CFTC is required (or an appropriate exemption from registration must be utilized) if managers plan to trade cryptocurrency futures on registered exchanges. Under the Commodity Exchange Act, many, if not all, derivatives based on digital assets must be traded on a Designated Contract Market (“DCM”). However, many managers prefer not to trade on DCMs due to the lack of volume and liquidity and instead seek to trade on offshore exchanges that offer higher volume and reduced margin requirements. We caution U.S. managers who are trading on such exchanges – there may be risks to engaging with such counterparties in foreign jurisdictions and such U.S. managers often are unable to make the representations required in the account opening paperwork or terms of service (e.g., that the trading activity will not occur in the U.S.). To our knowledge, the CFTC has yet to take any action against managers trading on such offshore exchanges; however, we believe it is only a matter of time. Managers should carefully diligence any offshore exchanges they may use and disclose any applicable risks to investors.

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Digital Asset Items

Coinbase’s Bankruptcy Disclosure. The industry was caught off guard when Coinbase filed its latest 10-Q filing in which it stated “custodially held crypto assets may be considered to be the property of a bankruptcy estate.” In essence, in the event of Coinbase’s bankruptcy, its customers’ crypto assets may not be returned, and such clients could be treated as general unsecured creditors, meaning they would not have a claim to specific crypto assets held with Coinbase and could only recover the value of their crypto assets to the extent the bankruptcy estate has assets remaining after more senior claims are satisfied. While the Coinbase founder and CEO subsequently tweeted that Coinbase’s statement was a response to SEC disclosure requirements and that “customers have strong legal protections…in a black swan event like this,” the bankruptcy risks that Coinbase disclosed remain a possibility, however remote. In addition, other crypto exchanges, as well as third party wallet providers and custodians, may be subject to similar bankruptcy risks even though they may not have an obligation to disclose such risks publicly like Coinbase. In light of Coinbase’s disclosures, managers who do not exclusively rely on self-custody or cold wallets should review their custody practices, policies, and procedures, as well as agreements with their service providers, to ensure they have taken all available steps to safeguard investor assets. Managers should also consider making additional risk disclosures in their fund offering documents or other investor communications to educate their investors on these potential bankruptcy risks.

Liability Issues for Investing in a DAO. Due to the emerging nature of, and the scarce legislation surrounding, Decentralized Autonomous Organizations (“DAOs”), operating, participating in, or investing in DAOs carries a heightened risk of liability as DAOs formed for the purpose of making a profit could be deemed general partnerships and therefore expose their participants to unlimited joint and several personal liability for the debts and obligations of such DAO. One recommendation to minimize exposure is to wrap the DAO in a liability blocker. As legislation related to, and use cases of, DAOs evolve and iterate, the need or effectiveness of liability blockers may change. Until then, managers should disclose this heightened risk to their investors and should consider only participating or investing in DAOs that are wrapped in a liability blocking entity such as a limited liability company.

Senators Introduce Bipartisan Crypto Regulatory Framework Bill. Sens. Kirsten Gillibrand (D-NY) and Cynthia Lummis (R-WY) recently introduced bipartisan legislation to regulate the cryptocurrency market. The Responsible Financial Innovation Act aims to create a clear standard for determining whether certain digital assets are commodities or securities. The bill would give the CFTC authority over digital asset spot markets, allowing the agency to regulate digital assets in the same way as more traditional commodities. The bill has been referred to the Senate Finance Committee for examination and is pending approval of the Senate and the House of Representative.

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Other Items

In-Kind Crypto Contributions / Redemptions. We are starting to see greater difficulty for managers of offshore funds to utilize in-kind crypto contributions and redemptions because of administrator and Anti Money Laundering (“AML”) officers’ unease. We expect this trend to generally continue until administrators and AML officers become more comfortable with verifying and authenticating in-kind crypto transactions, either with additional regulatory guidance or with innovative processes.

Investors with Connections to Russia. It may be simply anecdotal, but we are seeing more administrator inquiries regarding investors with ties to Russia who are flagged for potential sanctions issues. In these instances, we encourage clients to work with legal counsel and their administrator to analyze their specific facts and circumstances and determine an appropriate course of action.

NFTs. Although far removed from its headline status of 2021, the NFT ecosystem continues to evolve, and many groups are developing products for the sector that more closely mirror the traditional asset space. We anticipate continued growth in this area and the development of business, legal and regulatory norms.

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Compliance Calendar

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

July 10, 2022

• Form 13H Quarterly Filing for Changes. Filing is for calendar quarter that ended June 30, 2022 and should be submitted within 10 days of quarter end.

July 15, 2022

• Form PF for Large Liquidity Fund Advisers. Filing is for calendar quarter that ended June 30, 2022.

July 31, 2022

• ERISA Schedule C of DOL Form 5500 Disclosure.

August 15, 2022

• Form 13F Quarterly Filing. Filing is for calendar quarter that ended June 30, 2022 and should be submitted within 45 days of quarter end.
• CTA Form PR. Filing is for calendar quarter that ended June 30, 2022 and should be submitted within 45 days of quarter end.

August 29, 2022

• Form PF for Large Hedge Fund Advisers. Filing is for calendar quarter that ended June 30, 2022.
• CPO-PQR Form. Filing is for calendar quarter that ended June 30, 2022 and should be submitted within 60 days of quarter end.

August 31, 2022

• Deadline to submit Annual FINRA Entitlement Certification for 2022. If not completed, FINRA accounts will be withdrawn.

Consult our complete Compliance Calendar for all 2022 critical dates as you plan your regulatory compliance timeline for the year. 

Please contact us with any questions or assistance regarding compliance, registration, or planning issues on any of the above topics.

Sincerely,

Karl Cole-Frieman, Bart Mallon, David Rothschild, Scott Kitchens, Alex Yastremski, & Tony Wise

Cole-Frieman & Mallon LLP is an investment management law firm known for providing innovative and collaborative legal solutions to clients with complex financial needs in both the traditional and digital asset spaces. Headquartered in San Francisco, CFM services a wide variety of groups, from start-up investment managers to multi-billion-dollar firms. The firm provides a full suite of legal services including: formation of hedge funds, private equity funds, and venture capital funds; adviser compliance and registration; counterparty documentation; equity financings and token offerings; SEC, CFTC, NFA and FINRA matters; seed deals; hedge fund due diligence; employment and compensation matters; and, routine business matters. The Firm also publishes the prominent Hedge Fund Law Blog, which focuses on legal issues that impact the hedge fund community. For more information, please add us on LinkedIn and visit us at colefrieman.com.