July 20, 2023

Clients, Friends, and Associates:

As we end the second quarter and enter the summer season, we would like to highlight recent industry news that we found to be both interesting and impactful. While we try to summarize these topics at a 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 excited to announce that Cole-Frieman & Mallon LLP has added more expertise to its already stellar team. First, we welcome back Lilly Palmer as a Partner, whose extensive digital asset experience will benefit the firm and all its clients. We also welcome Bill Samuels to the firm, where he will lead a newly launched Intellectual Property practice with new Associate, Stavros Papadopoulos. Finally, we’re pleased to welcome Brett Bunnell as a Counsel and Thomas Gaffney as an Associate in our Corporate and Transactional practice group. We expect these additions to meaningfully contribute to our unwavering commitment to provide excellent legal services to all our clients. Please join us in welcoming them all to our firm.

Cole-Frieman & Mallon LLP, along with industry leaders MG Stover, Harneys, and KPMG, are premier sponsors of the CoinAlts Annual Fund Symposium on October 26, 2023, in San Francisco. Founded in 2017, this event brings together the digital asset community to address investment, legal, and operational issues relevant to private fund managers. The CoinAlts Annual Fund Symposium is a must-attend gathering for industry professionals, providing unparalleled insights and networking opportunities. Join us for expert panels, top-notch speakers, and the chance to stay ahead of the curve in this rapidly evolving industry. More information available at https://coinalts.xyz/.

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SEC Matters

SEC Enforcement Action Against Ripple. On July 13, 2023, the U.S. District Court of the Southern District of New York entered an order which granted in part and denied in part the cross-motions for summary judgment filed by the SEC and Ripple Labs, Inc. (“Ripple”). In December 2020, the SEC charged Ripple and two executives for engaging in unlawful offer and sales of securities in violation of the Exchange Act. The complaint alleged that since 2013, Ripple issued over 14.6 billion units of its native token, XRP, in exchange for consideration of over $1.38 billion without registering the offer and the sale of such token with the SEC. Notably, the July 2023 order stated that XRP “is not in and of itself a ‘contract, transaction[,] or scheme’ that embodies the Howey requirements of an investment contract”. In other words, XRP itself is not a security, and all the facts and circumstances surrounding specific transactions in XRP must be examined to determine whether an “investment contract,” as defined under the Howey test, was issued. As a reminder, the U.S. Supreme Court ruled in Howey that an investment contract requires a finding of an investment of money in a common enterprise with the reasonable expectation of profits derived from the efforts of others.

The District Court examined the sale and distribution of XRP in three types of transactions – direct sales of XRP to institutional investors, sales of XRP through crypto exchanges in blind bid/ask transactions, and distributions of XRP as payment for services to employees and service providers – and held that only the direct sales of XRP to institutional investors constituted an investment contract under the Howey test. While this order constitutes a significant win for Ripple, since it is a District Court order, it may not be the last word.

SEC Enforcement Action Against Coinbase. On June 6, 2023, the SEC charged Coinbase, Inc. and Coinbase Global, Inc. (collectively, “Coinbase”) for failure to register as an exchange, a broker-dealer and a clearing agency, and for failure to register the offering and sale of securities via the Coinbase trading platform in accordance with the Securities Exchange Act of 1934, as amended (the “Exchange Act”). This proceeding follows the Wells Notice that Coinbase received from the SEC in March 2023. The complaint alleges that Coinbase acted as an unregistered exchange, a broker-dealer, and a clearing agency by making available at least 13 crypto assets that are offered and sold as investment contracts on its platform. Additionally, the complaint alleges that Coinbase’s staking program should be considered an investment contract under the Howey test.

On June 28, 2023, Coinbase filed an answer to the SEC complaint denying that the digital assets listed on its platform constitute an investment contract or a security. Additionally, the answer noted that half of the tokens traded on Coinbase’s platform that the SEC alleged are securities were custodied and traded on its platform since April 2021 (i.e., when the SEC approved and declared Coinbase’s S-1 filing to be effective), and, at the time, the SEC did not identify such tokens as investment contracts or securities, nor allege that Coinbase was operating as an unregistered exchange, broker, and clearing agency within the meaning of federal securities law. Coinbase’s answer also denied the SEC’s allegation that its staking program is a security. In addition to filing the answer, Coinbase filed a letter to the court indicating its intention to file a motion to dismiss the complaint. Our firm will continue to closely monitor the situation with Coinbase for new developments.  

SEC Enforcement Action Against Bittrex and Bittrex’s Chapter 11 Bankruptcy. On April 17, 2023, the SEC charged Bittrex, Inc., Bittrex Global GmbH, and William Hiroaki Shihara, co-founder and former chief executive officer (collectively, “Bittrex”) for the failure to register as an exchange, a broker-dealer, and a clearing agency, pursuant to the Exchange Act.  

On March 31, 2023, Bittrex issued a statement that it began the process of winding down its U.S. operations.  Shortly after the SEC’s complaint, Bittrex ceased its operations in the U.S. and filed for Chapter 11 bankruptcy. On June 13, 2023, the U.S. Bankruptcy Court for the District of Delaware entered an order permitting Bittrex to allow its customers to access and withdraw crypto assets and fiat currency from Bittrex’s trading platform.

The Hinman Speech Documents. On June 13, 2023, the SEC internal communication documents related to William Hinman’s speech on digital asset transactions on June 14, 2018 were released to the public. The documents were made available to the public following an order entered by the U.S. District Court Southern District of New York denying the SEC’s motion to seal the SEC internal communication documents related to William Hinman’s 2018 speech in connection with its lawsuit against Ripple.

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CFTC Items

CFTC Enforcement Action Against Ooki DAO. On June 8, 2023, the U.S. District Court for the Northern District of California entered an order granting the CFTC’s motion for default judgment in its lawsuit against Ooki Dao (formerly bZx DAO), a decentralized autonomous organization and an unincorporated association comprised of holders of OokiDAO Tokens. For background, on September 22, 2022, the CFTC charged Ooki DAO for engaging in unlawful off-exchange leveraged and margined retail commodity transactions, engaging in activities performed by a registered futures commission merchant, and failing to implement appropriate Customer Information Program/KYC/AML procedures in violation of the Commodity Exchange Act of 1936, as amended (the “CEA”). The court granted the motion for default judgement in part due to neither Ooki Dao nor a representative of Ooki Dao appearing or participating in the action (the court previously held that the CFTC had properly served Ooki Dao when it provided notice of the action via the “Help Chat Box” and the discussion forum on Ooki Dao’s public website). In addition to granting default judgment against Ooki DAO on all accounts, the court also enjoined Ooki DAO from further violation of the CEA and ordered Ooki DAO to pay a civil penalty of $643,542. Importantly, Ooki DAO token holders bear some responsibility of the civil penalty, and the case underscores the need of fund managers to limit their investments in DAOs to those that have been legally wrapped and make such investments via special purpose vehicle in an attempt to achieve another layer of liability protection, as noted in our July 2022 Quarterly Update.

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Digital Asset Items

SEC and CFTC Enforcement Actions Against Binance. On June 5, 2023, the SEC charged Binance Holdings Limited, BAM Trading Services Inc., BAM Management US Holdings Inc., and Changpeng Zhao, founder and chief executive officer (collectively, “Binance”), for failure to register as an exchange, a broker-dealer, and a clearing agency, and failure to register the offering and sale of securities via the Binance trading platform in accordance with the Exchange Act. Notably, the complaint also charged Binance for making false representations about the presence of trading surveillance for the detection and prevention of manipulative trading and false statements with respect to the trading volumes on its platform to the public (the SEC did not include such allegations in its complaint against Coinbase).  
 
The SEC complaint was preceded by the CFTC’s complaint filed against Binance on March 27, 2023. The CFTC complaint included an allegation that despite Binance’s implementation of an IP address-based compliance control, such measure had not been effective in preventing U.S.-based customers from accessing and trading on the Binance platform. In fact, Binance’s financial reports reflect that U.S.-based customers contributed substantially to Binance’s revenues. The CFTC complaint also contains detailed and specific allegations regarding Binance’s reliance upon “prime brokers” to facilitate such U.S-based customers’ access to Binance. The prime brokers are alleged to have provided details to such U.S.-based customer to assist in their access to the exchange. Given the details of such allegations, digital asset fund managers should continue to assess how they are accessing digital asset exchanges.
 
Proposed Legislation – Digital Asset Market Structure Bill. Representatives Patrick McHenry (R-NC) and Glenn Thompson (R-PA) proposed the Digital Asset Market Structure Bill (the “Bill”) in a discussion draft reflecting a joint-committee effort to add clarity to the regulatory uncertainty surrounding digital assets in the U.S. The Bill included a proposal to delegate authority to the SEC and the CFTC to jointly issue rules for (i) the definition of a number of digital asset related terms, including blockchain, blockchain network, digital assets, etc., and (ii) rules to exempt the requirement to register with both the CFTC as a digital commodity exchange and the SEC as an alternative trading system to the extent such exemption would foster the development of digital assets for the benefit of the public interest and protection of investors. The Bill also proposed the establishment of a strategic hub for innovation and financial technology and a LabCFTC within the SEC and the CFTC, respectively, with the purpose of educating and advising the regulators on financial technology. Additionally, the Bill further proposed that the SEC and the CFTC form a joint committee on digital assets with the purpose of providing advice on rules, regulations, and policies relating to digital assets, as well as harmonizing policies between the SEC and the CFTC.

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Other Items

SEC Amendments to Form PF. On May 3, 2023, the SEC adopted certain amendments to Form PF, a regulatory filing requirement that mandates certain SEC registered investment advisers to report information to the Financial Stability Oversight Council (“FSOC”). Form PF was created in 2011 by Title IV of the Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010, as amended (the “Dodd-Frank Act”).
      
The amendments included a number of changes to the existing Form PF. Specifically, the amendments introduced a new Section 5 to Form PF and required, upon an occurrence of a trigger event, large hedge fund advisers of qualifying hedge funds to file a current report as soon as practicable but no later than 72 hours after such event. Triggering events include extraordinary investment loss, a significant margin and default event, fund margin default or inability to meet margin call, and significant disruption or degradation of the reporting fund’s key operations. Additionally, Section 6 of Form PF has been amended to require private equity fund advisers to report certain trigger events within 60 days of the end of each fiscal quarter. Such trigger events include the execution of an adviser-led secondary transaction and the investor’s election for the removal of the general partner to the fund, termination of the fund’s investment period, or termination of the fund. Section 4 of Form PF also introduced a new annual reporting event to large advisers of private equity funds with respect to the implementation of a general partner or limited partner clawbacks.
 
The amendments to Form PF Sections 5 and 6 will become effective on December 11, 2023, with the remainder of the amendments to Form PF becoming effective on June 22, 2024.
 
Enforcement of California Privacy Rights Act. The California Consumer Privacy Act of 2018 (the “CCPA”), as amended by the California Privacy Rights Act of 2020 (the “CPRA”, and together with the CCPA, the “Act”), was scheduled to become fully enforceable by the California Privacy Protection Agency (the “CPPA”) on July 1, 2023; however, a recent California court case has delayed this enforcement date, at least in relation to some of the statute’s requirements. By way of background, the CPRA amended the CCPA to add additional consumer data protections and created the CPPA, a state agency empowered to not only enforce these requirements jointly with the Attorney General of California, but also to promulgate final regulations thereunder.  Incidentally, the CPRA required the regulations to be completed by July 1, 2022, and contemplated a one-year “pre-enforcement period” by providing that enforcement of the regulations, “[n]otwithstanding any other law, civil and administrative enforcement…shall not commence until July 1, 2023[.]”
 
Unfortunately, the CPPA failed to complete the regulations by July 1, 2022. On March 29, 2023, the CPPA issued final (but incomplete) regulations, relating to twelve of the fifteen topics contemplated by the CPRA.  Currently, there are still no regulations concerning three key elements of the CPRA – cybersecurity audits, risk assessments, and automated decision-making technology.

The California Chamber of Commerce sued the CPPA, seeking to delay the enforcement of the Act, arguing that since the regulations were only finalized on March 29, 2023, an enforcement date of July 1, 2023 would violate the one-year pre-enforcement period required by the CPRA’s express language. On June 30, 2023, the Sacramento County Superior Court held that the CPPA cannot enforce any of the regulations of the Act before one year has passed from the date any such regulation has been finalized by the CPPA.
 
As the saga of California’s privacy statute continues to play out, businesses subject to the Act should resist the urge to fall into a false sense of security that compliance with the Act is neither imminent nor important.  The Act requires fundamental privacy controls that must be imbued into an organization on numerous planes — culturally, operationally, and technologically – simultaneously. CFM will continue to monitor this situation and advise our clients accordingly.

Establishment of an Ethical Artificial Intelligence Framework for Investment Advisors. On April 6, 2023, the SEC Investor Advisory Committee (the “IAC”) wrote an open letter to SEC Chair Gary Gensler outlining its views on implementing an ethical artificial intelligence (“AI”) framework for investment advisers and financial institutions. The letter referenced the use of algorithmic models and code by investment advisory firms and warned that the use of AI in other industries has highlighted important risks such as harmful algorithmic biases.
             
The letter encouraged the SEC and its staff to consider the following key tenets in developing guidance to investment advisers on the ethical use of AI:

• Equity – understanding of the contextual, historical, and structural problems of the underlying data selected for input, including seeking consultation of experts.
• Consistent and Persistent Testing – consistent testing of algorithms for performance during pre and post implementation stage.
• Governance and Oversight – incorporation of a comprehensive risk management and compliance policy. 

The letter concluded with additional proposals to the SEC for consideration in developing its best practices guidance on ethical use of AI, including the hiring of staffs with experience in AI and machine learning, the reviewing of AI-related frameworks developed by other regulators such the Federal Trade Commission and the National Institute of Standards of Technology, and tasking the Division of Examinations to monitor the compliance on ethical use of AI.

User Fees and Third-Party Examination of SEC Registered Investment Adviser. On June 5, 2023, the IAC drafted a list of recommendations on oversight of SEC registered investment advisers (“RIAs”) to be discussed at the IAC meeting on June 22, 2023. The draft included two recommendations. First, the imposition of “user fees” on SEC RIAs to fund the SEC’s investment adviser examination program and to achieve an acceptable frequency of examination of SEC RIAs once every four to five years. Second, the adoption of a rule requiring SEC RIAs to undergo examination conducted by an outside firm, with a copy of the exam results submitted to the SEC. 

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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, 2023

• Form 13H Filing for Changes. Filing is for calendar quarter that ended June 30, 2023 and should be submitted within 10 days of quarter end.

July 14, 2023

• Form PF Quarterly Filing for Large Liquidity Fund Advisers. Filing is for the calendar quarter that ended June 30, 2023.

July 31, 2023

• ERISA Schedule C of DOL Form 5500 Disclosure.

August 14, 2023

• Form 13F Quarterly Filing. Filing is for calendar quarter that ended June 30, 2023 and should be submitted within 45 days of quarter end.
• CTA Form PR. Filing is for calendar quarter that ended June 30, 2023 and should be submitted within 45 days of quarter end.

August 29, 2023

• Form PF for Large Hedge Fund Advisers. Filing is for calendar quarter that ended June 30, 2023.
• CPO-PQR Form. Filing is for calendar quarter that ended June 30, 2023 and should be submitted within 60 days of quarter end.

Periodic

• Form D and Blue Sky Filings should be current.
• CPO/CTA Annual Questionnaires must be submitted annually, and promptly upon material information changes, through the NFA Annual Questionnaire system.

Consult our complete Compliance Calendar for all 2023 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, Lilly Palmer, David Rothschild, Scott Kitchens, Tony Wise, Alex Yastremski, Garret Filler, John T. Araneo, Frank J. Martin, and Bill Samuels 

Cole-Frieman & Mallon LLP is a leading investment management law firm known for providing top-tier, innovative, and collaborative legal solutions for complex financial services matters. Headquartered in San Francisco, Cole-Frieman & Mallon LLP services both start-up investment managers and multibillion-dollar funds. The firm provides a full suite of legal services to the investment management community, including fund formation (hedge, VC, PE, real estate), investment adviser and CPO registration, counterparty documentation (digital and traditional prime brokerage, ISDA, repo, and vendor agreements), SEC, CFTC, NFA and FINRA matters (inquiries, exams, and compliance issues), seed deals, cybersecurity regulatory matters, full-service intellectual property counsel, manager due diligence, employment and compensation matters, and routine business matters. The firm also publishes the prominent Hedge Fund Law Blog. For more information, please add us on LinkedIn, follow us on Twitter, and visit us at colefrieman.com.