December 2022
Clients, Friends, Associates:
As we near the end of 2022, we have highlighted some recent industry updates that we believe may impact our clients. We have also developed a checklist to help managers effectively oversee the business and regulatory landscape for the coming year. While we strive to present an informative, albeit brief, overview of these topics, we are also available should you have any related questions.
This update includes the following:
- Q4 Matters
- Annual Compliance & Other Items
- Annual Fund Matters
- Annual Management Company Matters
- Notable Regulatory & Other Items from 2022
- Compliance Calendar
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Q4 Matters
New York Federal Reserve Digital Dollar Pilot Project. In collaboration with the Federal Reserve Bank of New York and several private sector financial institutions, the New York Innovation Center (“NYIC”) recently announced a pilot program to test the operability of digital asset transactions between financial institutions using the U.S. dollar as token. Although the project is being conducted in a purely experimental fashion using simulated data, the pilot can be seen as one of the first steps taken by a governmental agency towards creating a central bank digital currency.
SEC v. LBRY. In November, the U.S. District Court for the District of New Hampshire granted the SEC’s motion for summary judgment against LBRY, Inc., holding that LBRY offered a crypto asset in violation of the registration provisions of federal securities laws. The case addresses a fundamental issue in the crypto universe — whether blockchain tokens are considered securities by the SEC. The Court concluded that LBRY’s messaging would lead potential investors to understand that the company was pitching speculative value propositions for its digital token that created an expectation of profits under the Howey test. We generally advise that managers and others in the digital asset space should assume that the SEC considers all blockchain tokens to be securities, subject to SEC regulation and applicable registration requirements.
FTX. Our firm, like many others, continues to develop our understanding of the recent events related to FTX, what users of the exchange can and should expect going forward, and how it will affect the digital asset space generally. We have included links to our initial blog post and podcast below touching on the FTX situation. Stay tuned for additional information through multiple channels in the days and weeks ahead.
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Annual Compliance & Other Items
Annual Privacy Policy Notice. On an annual basis, SEC-registered investment advisers (“SEC RIAs”) are required to provide natural person clients with a copy of the firm’s privacy policy if: (i) the SEC RIA has disclosed nonpublic personal information other than in connection with servicing consumer accounts or administering financial products; or (ii) the firm’s privacy policy has changed. The SEC has provided a model form and accompanying instructions for firm privacy policies.
Annual Compliance Review. The Chief Compliance Officer (“CCO”) of a registered investment advisor (“RIA”) must conduct a review of the adviser’s compliance policies and procedures annually. This annual compliance review should be in writing and presented to senior management. CCOs should consider additions, revisions, and updates to the compliance program as may be necessary. We recommend firms discuss the annual review with their outside counsel or compliance firm to obtain guidance about the review process and a template for the assessment. Conversations regarding the annual review may raise sensitive matters, and advisers should ensure that these discussions are protected by attorney-client privilege. Advisers that are not registered may still wish to review their procedures and/or implement a compliance program as a best practice.
Form ADV Annual Amendment. RIAs or managers filing as exempt reporting advisers (“ERAs”) with the SEC or a state securities authority must file an annual amendment to their Form ADV within 90 days of the end of their fiscal year. For most managers, the Form ADV amendment will be due on March 31, 2023. RIAs must provide a copy of the updated Form ADV Part 2A brochure and Part 2B brochure supplement (or a summary of changes with an offer to provide the complete brochure) to each “client” and, if applicable, Part 3 (Form CRS: Client Relationship Summary) to each “retail investor” with which the RIA has entered into an investment advisory contract. Note that for SEC RIAs to private investment vehicles, a “client” for purposes of this rule refers to the vehicle(s) managed by the adviser and not the underlying investors. State-registered advisers need to examine their states’ regulations to determine who constitutes a “client.” For purposes of the Form ADV Part 3, a “retail investor” means a natural person, or the legal representative of such natural person, who seeks to receive or receives services primarily for personal, family, or household purposes.
Switching to/from SEC Regulation.
SEC Registration. Managers who no longer qualify for SEC registration as of the time of filing the annual Form ADV amendment must withdraw from SEC registration within 180 days after the end of their fiscal year (June 30, 2023, for most managers), by filing a Form ADV-W. Such managers should consult with legal counsel to determine whether they are required to register in the states in which they conduct business. Managers who are required to register with the SEC as of the date of their annual amendment must register with the SEC within 90 days of filing the annual amendment (June 30, 2023, for most managers, assuming the annual amendment is filed on March 31, 2023).
Exempt Reporting Advisers. Managers who no longer meet the definition of an ERA will need to submit a final report as an ERA and apply for registration with the SEC or the relevant state securities authority, as applicable, generally within 90 days after the filing of the annual amendment (June 30, 2023, for most managers, assuming the annual amendment is filed on March 31, 2023).
Custody Rule Annual Audit.
SEC RIAs. SEC RIAs must comply with specific custody procedures, including: (i) maintaining client funds and securities with a qualified custodian; (ii) having a reasonable basis to believe that the qualified custodian sends an account statement to each advisory client at least quarterly; and (iii) undergoing an annual surprise examination conducted by an independent public accountant.
SEC RIAs to pooled investment vehicles may avoid both the quarterly statement and surprise examination requirements by having audited financial statements prepared for each pooled investment vehicle in accordance with generally accepted accounting principles (“GAAP”) by an independent public accountant registered with the Public Company Accounting Oversight Board (“PCAOB”). Audited financial statements must be sent to investors in the fund within 120 days after the fund’s fiscal year-end (or for fund-of-fund clients, within 180 days after fiscal year-end). SEC RIAs should review their internal procedures to ensure compliance with the custody rules.
California RIAs. California-registered investment advisers (“CA RIAs”) that manage pooled investment vehicles and are deemed to have custody of client assets are also subject to independent party surprise examinations. However, CA RIAs can avoid these additional requirements by engaging a PCAOB-registered auditor to prepare and distribute audited financial statements to all beneficial owners of the pooled investment vehicle, and the Commissioner of the California Department of Financial Protection and Innovation (“DFPI”). Those CA RIAs that do not engage an auditor must, among other things: (i) provide notice of such custody on the Form ADV; (ii) maintain client assets with a qualified custodian; (iii) engage an independent party to act in the best interest of investors to review fees, expenses, and withdrawals; and (iv) retain an independent certified public accountant to conduct surprise examinations of assets.
Other State RIAs. Advisers registered in other states should consult their legal counsel about those states’ specific custody requirements.
California Minimum Net Worth Requirement and Financial Reports.
CA RIAs with Discretion. Every CA RIA (other than those also registered as broker-dealers) that has discretionary authority over client funds or securities, regardless of if they have custody, must maintain a net worth of at least $10,000 (CA RIAs with custody are subject to heightened minimum net worth requirements, discussed further below).
CA RIAs with Custody. Generally, every CA RIA (other than those also registered as broker-dealers) that has custody of client funds or securities must maintain a minimum net worth of $35,000. However, a CA RIA that: (i) is deemed to have custody solely because it acts as the general partner of a limited partnership, or a comparable position for another type of pooled investment vehicle; and (ii) otherwise complies with the California custody rule described above is exempt from the $35,000 minimum (and instead is required to maintain the $10,000 minimum).
Financial Reports. Every CA RIA subject to the above minimum net worth requirements must file certain reports with the DFPI. In addition to annual reports, CA RIAs may be required to file interim reports or reports of financial condition if they fall below certain net worth thresholds.
Annual Re-Certification of CFTC Exemptions. Commodity pool operators (“CPOs”) and commodity trading advisers (“CTAs”) currently relying on certain exemptions from registration with the Commodity Futures Trading Commission (“CFTC”) are required to re-certify their eligibility within 60 days of the calendar year-end. A common example includes the 4.13(a)(3) exemption also known as the “de minimis” exemption. CPOs and CTAs currently relying on relevant exemptions should consult with legal counsel to evaluate whether they remain eligible to rely on such exemptions.
CPO and CTA Annual Updates. Registered CPOs and CTAs must prepare and file Annual Questionnaires and Annual Registration Updates with the National Futures Association (“NFA”), as well as submit payment for annual maintenance fees and NFA membership dues. Registered CPOs must also prepare and file their fourth-quarter report for each commodity pool on Form CPO-PQR, while CTAs must file their fourth-quarter report on Form CTA-PR. Unless eligible to claim relief under Regulation 4.7, registered CPOs and CTAs must update their disclosure documents periodically, as they may not use any document dated more than 12 months prior to the date of its intended use. Disclosure documents that are materially inaccurate or incomplete must be promptly corrected, and redistributed to pool participants.
Trade Errors. Managers should ensure that all trade errors are properly addressed pursuant to the manager’s trade errors policies by the end of the year. Documentation of trade errors should be finalized, and if the manager is required to reimburse any of its funds or other clients, it should do so by year-end.
Soft Dollars. Managers that participate in soft dollar programs should make sure that they have addressed any commission balances from the previous year.
Schedule 13G/D and Section 16 Filings. Managers who exercise investment discretion over accounts (including funds and separately managed accounts) that are beneficial owners of 5% or more of a registered voting equity security must report these positions on Schedule 13D or 13G. Passive investors are generally eligible to file the short-form Schedule 13G, which is updated annually within 45 days of the end of the year. Schedule 13D is required when a manager is ineligible to file Schedule 13G and is due 10 days after acquiring more than 5% beneficial ownership of a registered voting equity security. For managers who are also making Section 16 filings, this is an opportune time to review your filings to confirm compliance and anticipate needs for the first quarter.
Section 16 filings are required for “corporate insiders” (including beneficial owners of 10% or more of a registered voting equity security). An initial Form 3 is due within 10 days after becoming an “insider”; Form 4 reports ownership changes and is due by the end of the second business day after an ownership change; and Form 5 reports any transactions that should have been reported earlier on a Form 4 or were eligible for deferred reporting and is due within 45 days after the end of each fiscal year.
Form 13F. A manager must file a Form 13F if it exercises investment discretion with respect to $100 million or more in certain “Section 13F securities” within 45 days after the end of the year in which the manager reaches the $100 million filing threshold. The SEC lists the securities subject to 13F reporting on its website.
Form 13H. Managers who meet one of the SEC’s large trader thresholds (generally, managers whose transactions in exchange-listed securities equal or exceed two million shares or $20 million during any calendar day, or 20 million shares or $200 million during any calendar month) are required to file an initial Form 13H with the SEC within 10 days of crossing a threshold. Large traders also need to amend Form 13H annually within 45 days of the end of the year. In addition, changes to the information on Form 13H will require interim amendments following the calendar quarter in which the change occurred.
Form PF. Managers to private funds that are either registered with the SEC or required to be registered with the SEC and who have at least $150 million in regulatory assets under management (“RAUM”) must file a Form PF. Private advisers with less than $1.5 billion in RAUM must file Form PF annually within 120 days of their fiscal year-end. Private advisers with $1.5 billion or more in RAUM must file Form PF within 60 days of the end of each fiscal quarter.
Form MA. Investment advisers that provide advice on municipal financial products are considered “municipal advisors” by the SEC and must file a Form MA annually, within 90 days of their fiscal year-end.
SEC Form D. Form D filings for most funds need to be amended annually, on or before the anniversary of the most recently filed Form D. Copies of Form D are publicly available on the SEC’s EDGAR website.
Blue Sky Filings. On an annual basis, a manager should review its blue sky filings for each state to make sure it has met any initial and renewal filing requirements. Several states impose late fees or reject late filings altogether. Accordingly, it is critical to stay on top of filing deadlines for both new investors and renewals. We also recommend that managers review blue sky filing submission requirements. Many states now permit blue sky filings to be filed electronically through the Electronic Filing Depository (“EFD”) system, and certain states will now only accept filings through EFD.
IARD Annual Fees. Preliminary annual renewal fees for state-registered and SEC-registered investment advisers are due on December 13, 2022. Failure to submit electronic payments by the deadline may result in registrations terminating due to a “failure to renew.” If you have not already done so, you should submit full payment into your Renewal Account by E-Bill, check, or wire as soon as possible.
Pay-to-Play and Lobbyist Rules. SEC rules disqualify investment advisers, their key personnel, and placement agents acting on their behalf from seeking to be engaged by a governmental client if they have made certain political contributions. State and local governments have similar rules, including California, which requires internal sales professionals who meet the definition of “placement agents” (people who act for compensation as finders, solicitors, marketers, consultants, brokers, or other intermediaries in connection with offering or selling investment advisory services to a state public retirement system in California) to register with the state as lobbyists and comply with California lobbyist reporting and regulatory requirements. Note that managers offering or selling investment advisory services to local government entities must register as lobbyists in the applicable cities and counties. State laws on lobbyist registration differ significantly, so managers should carefully review reporting requirements in the states in which they operate to make sure they comply with the relevant rules.
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Annual Fund Matters
New Issue Status. On an annual basis, managers need to confirm or reconfirm the eligibility of investors that participate in initial public offerings, or new issues, pursuant to both Financial Industry Regulatory Authority, Inc. (“FINRA”) Rules 5130 and 5131. Most managers reconfirm investor eligibility via negative consent (i.e., investors are informed of their status on file with the manager and are asked to notify the manager of any changes), whereby a failure to respond by any investor operates as consent to its current status.
ERISA Status. Given the significant problems that can occur from not properly tracking ERISA investors in private funds, we recommend that managers confirm or reconfirm on an annual basis the ERISA status of their investors. This is particularly important for managers that track the underlying percentage of ERISA funds for each investor, with respect to each class of interests in a pooled investment vehicle.
Wash Sales. Managers should carefully manage wash sales for year-end. Failure to do so could result in book/tax differences for investors. Certain dealers can provide managers with swap strategies to manage wash sales, including Basket Total Return Swaps and Split Strike Forward Conversion. These strategies should be considered carefully to make sure they are consistent with the investment objectives of the fund.
Redemption Management. Managers with significant redemptions at the end of the year should carefully manage unwinding positions to minimize transaction costs in the current year (that could impact performance) and prevent transaction costs from impacting remaining investors in the next year. When closing funds or managed accounts, managers should pay careful attention to the liquidation procedures in the fund constituent documents and the managed account agreement.
NAV Triggers and Waivers. Managers should promptly seek waivers of any applicable termination events specified in a fund’s International Swaps and Derivatives Association (“ISDA”) or other counterparty agreement that may be triggered by redemptions, performance, or a combination of both at the end of the year (NAV declines are common counterparty agreement termination events).
Fund Expenses. Managers should wrap up all fund expenses for 2022 if they have not already done so. In particular, managers should contact their outside legal counsel to obtain accurate and up to date information about legal expenses for inclusion in the NAV for year-end performance.
Electronic Schedule K-1s. The Internal Revenue Service (“IRS”) authorizes partnerships and limited liability companies taxed as partnerships to issue Schedule K-1s to investors solely by electronic means, provided the partnership has received the investors’ affirmative consent. States may have different rules regarding electronic K-1s, and partnerships should check with their counsel whether they may be required to send hard copy state K-1s. Partnerships must also provide each investor with specific disclosures that include a description of the hardware and software necessary to access the electronic K-1s, how long the consent is effective, and the procedures for withdrawing the consent. If you would like to send K-1s to your investors electronically, you should discuss your options with your service providers.
“Bad Actor” Recertification Requirement. A security offering cannot rely on the Rule 506 safe harbor from SEC registration if the issuer or its “covered persons” are “bad actors.” Fund managers must determine whether they are subject to the bad actor disqualification any time they are offering or selling securities in reliance on Rule 506. The SEC has advised that an issuer may reasonably rely on a covered person’s agreement to provide notice of a potential or actual bad actor triggering event pursuant to contractual covenants, bylaw requirements, or undertakings in a questionnaire or certification. However, if an offering is continuous, delayed or long-lived, issuers must periodically update their factual inquiry through a bring-down of representations, questionnaires, and certifications, negative consent letters, reexamination of public databases or other means, depending on the circumstances. Fund managers should consult with counsel to determine how frequently such an update is required. As a matter of practice, most fund managers should perform these updates at least annually.
U.S. FATCA. Funds should monitor their compliance with the U.S. Foreign Account Tax Compliance Act (“FATCA”). Generally, U.S. FATCA reports are due to the IRS on March 31, 2023, or September 30, 2023, depending on where the fund is domiciled. However, reports may be required by an earlier date for jurisdictions that are parties to intergovernmental agreements (“IGAs”) with the U.S. Additionally, the U.S. may require that reports be submitted through the appropriate local tax authority in the applicable IGA jurisdiction, rather than the IRS. Given the varying U.S. FATCA requirements applicable to different jurisdictions, managers should review and confirm the specific U.S. FATCA reporting requirements that may apply. As a reminder, we strongly encourage managers to file the required reports and notifications, even if they already missed previous deadlines. Applicable jurisdictions may be increasing enforcement and monitoring of FATCA reporting and imposing penalties for each day late.
CRS. Funds should also monitor their compliance with the Organisation for Economic Cooperation and Development’s Common Reporting Standard (“CRS”). All “Financial Institutions” in the British Virgin Islands (“BVI”) and the Cayman Islands must register with the respective jurisdiction’s Tax Information Authority and submit various reports with the applicable regulator via the associated online portal. Managers to funds domiciled in other jurisdictions should also confirm whether any CRS reporting will be required in such jurisdictions and the procedures required to enroll and file annual reports. We recommend managers contact their tax advisors to stay on top of the U.S. FATCA and CRS requirements and avoid potential penalties.
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Annual Management Company Matters
Management Company Expenses. Managers who distribute profits annually should attempt to address management company expenses in the year they are incurred. If ownership or profit percentages are adjusted at the end of the year, a failure to manage expenses could significantly impact the economics of the partnership or the management company.
Employee Reviews. An effective annual review process is vital to reduce the risk of employment-related litigation and protect the management company in the event of such litigation. Moreover, it is an opportunity to provide context for bonuses, compensation adjustments, employee goals, and other employee-facing matters at the firm. It is never too late to put an annual review process in place.
Compensation Planning. In the fund industry, and the financial services industry in general, the end of the year is the appropriate time to make adjustments to compensation programs. Because much of a manager’s revenue is tied to annual income from incentive fees, any changes to the management company structure, affiliated partnerships, or any shadow equity programs should be effective on the first of the year. Partnership agreements and operating agreements should be appropriately updated to reflect any such changes.
Insurance. If a manager carries director and officer or other liability insurance, the policy should be reviewed annually to ensure that the manager has provided notice to the carrier of all claims and all potential claims. Newly launched funds should also be added to the policy as necessary.
Other Tax Considerations. Fund managers should assess their overall tax position and consider several steps to optimize tax liability. Managers should also be aware of self-employment taxes, which can potentially be minimized by structuring the investment manager as a limited partnership. Several steps are available to optimize tax liability, including: (i) changing the incentive fee to an incentive allocation; (ii) use of stock-settled stock appreciation rights; (iii) if appropriate, terminating swaps and realizing net losses; (iv) making a Section 481(a) election under the Internal Revenue Code of 1986, as amended (“Code”); (v) making a Section 475 election under the Code; and (vi) making charitable contributions. Managers should consult legal and tax professionals to evaluate whether any of these options are appropriate.
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Notable Regulatory & Other Items from 2022
SEC Matters
SEC Risk Alert on Material Non-Public Information Compliance Issues. In April, the SEC 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.
Insider Trading in the Digital Asset Space. In 2022, the SEC charged a former Coinbase employee and two others with insider trading and a high-ranking employee of OpenSea was indicted for wire fraud and money laundering. The actions indicate the willingness of federal and state officials to enforce regulations applicable to traditional finance in the digital assets space and that law enforcement is ready to tackle unsavory business practices and to attempt to provide greater consumer protections. 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 an RIA 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 stable coins. 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.
New Marketing Rule for SEC Registered Investment Advisers. By November 4, 2022, all SEC RIA are required to be in full compliance with the SEC’s new marketing rules. As discussed in our 2021 Half Year Update, the new rule replaces the existing cash solicitation and advertising rules, with the most notable change being the allowance of testimonials and endorsements in a RIA’s marketing materials. Given the new rule’s detailed amendments and its significance to our investment adviser clients, we will soon publish a “Frequently Asked Questions” article addressing the specific changes and what they mean for investment advisers going forward. Please keep an eye out for this post on the Hedge Fund Law Blog in the coming weeks.
SEC Charges Investment Advisers for Non-Compliance with Reporting Requirements. In September, the SEC conducted a compliance sweep and charged nine investment advisers for various violations, including failing to deliver audited financial statements to investors in a timely manner, failing to promptly file required amendments to the adviser’s Form ADV upon receipt of audited financial statements, failing to properly describe the status of financial statement audits in the Form ADV, and other violations of Rule 206(4)-2 (the “Custody Rule”) of the Investment Advisers Act of 1940, as amended (the “Advisers Act”). Without admitting fault, all the advisers settled with the SEC and agreed to censure and penalties totaling over $1 million. These enforcement actions highlight the importance of compliance with the Custody Rule and its associated reporting requirements, as well as serve as a reminder to regularly review the Form ADV for accuracy and file timely updates as needed. Further, as specifically identified by the SEC in many of these enforcement actions, if you select “Report Not Yet Received” in Item 23(h) of Section 7.B(1) of the Form ADV regarding a private fund’s audited financial statements, the Custody Rule and related instructions to the Form ADV mandate the filing of an other than annual amendment to the Form ADV once the audited financial statements are available.
SEC Charges Venture Capital Adviser for Overcharging Fees. In September, the SEC charged a California-based ERA for overcharging management fees. The excess fees were a result of errors made by the manager, specifically with regard to (i) the failure to adjust its management fee calculations for securities subject to dispositions; (ii) calculations of the management fee based on aggregated invested capital at the portfolio company level instead of at the individual portfolio company level; (iii) including accrued but unpaid interest in its calculation of management fees; and (iv) calculating the funds’ post-investment period management fees on an incorrect date. As a result, the manager was ordered to return the excess management fees to fund investors and pay a penalty. This enforcement action underscores that while ERAs are subject to less regulatory oversight compared to RIAs, they are not exempt from SEC scrutiny. We recommend that all investment advisers routinely review their offering documents to ensure compliance with their fund offering terms.
SEC Pay-to-Play Rule. Rule 206(4)-5 of the Advisers Act bars investment advisers (except state registered investment advisers) from receiving compensation for advisory services provided to a government entity for two years after the adviser or its covered associates have made political contributions to that government entity or official. In September, the SEC investigated and settled four enforcement actions against investment advisers for violations of these pay-to-play rules as a result of political contributions of less than $1,000 by personnel of the investment advisers. The lack of allegations of an intent to exert influence highlights the strict liability enforcement mentality of the SEC with respect to pay-to-play rules as well as the importance of educating employees about political donations and implementing a robust internal compliance and reporting system.
CFTC Matters
Perpetual Futures and CFTC Regulation. Digital assets managers continue to inquire into the possibility of trading cryptocurrency futures contracts. With the 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 formal 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.
CFTC & SEC Consider Asking Large Hedge Funds to Disclose Crypto Exposure. In September, the CFTC and the SEC submitted a joint proposal to amend Form PF—a confidential reporting form for certain investment advisers to private funds that are registered with the SEC and/or the CFTC. The proposal observes that investments in digital assets are continuing to grow, and ultimately suggests there is a parallel need to gather information on the exposure of crypto funds. The proposal suggests a new asset class be created for digital assets, which would be reported by firms or funds separately, revealing their exposure to the crypto industry. Both agencies solicited comments through October 11, 2022 and the comments submitted prior to the deadline are available to the public. This proposal is one of many actions underway by U.S. government agencies to better understand and regulate crypto as an asset class. To the extent this proposal is part of a larger regulatory scheme that provides clarity as to how and to what extent digital assets will be regulated, we think this has the potential to increase investments in the crypto industry.
Digital Asset Matters
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. In June, Sens. Kirsten Gillibrand (D-NY) and Cynthia Lummis (R-WY) 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.
OFAC/Tornado Cash. In August, the U.S. Office of Foreign Assets Control (“OFAC”) added Tornado Cash, a smart contract mixer that anonymizes Ethereum-based crypto exchanges, to the Specially Designated National (“SDN”) list for the alleged use of its services in laundering over $7 billion of digital assets. By taking this position, OFAC has essentially declared that anonymous exchanges are likely SDNs, effectively denying these exchanges access to the U.S. financial system by making it illegal for any U.S. person to transact using those exchanges – even if the U.S. person does not initiate or authorize the transaction via the SDN. This is particularly concerning because users may lose real-world access to their cryptocurrency, likely without any recourse and even when they have not actively engaged with an SDN.
SEC Actions Against Sponsors of Unregistered Crypto Offerings. Since October, the SEC ramped up its investigation and enforcement of securities violations in the crypto asset space. Notably, the SEC brought an enforcement action against Kim Kardashian for promoting a crypto asset via social media without disclosing that she was being compensated by the entity offering the security. Several other groups were charged for allegedly raising millions of dollars for tokens and other crypto assets without adequate registration and from unsophisticated investors. The recent expansion of the SEC’s enforcement unit coupled with the wave of enforcement actions in the digital asset space indicates a shift in focus to digital assets.
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.
New EU AML Regulator Will Oversee Crypto. In June, the European Union (the “EU”) proposed the establishment of a new Anti-Money Laundering Authority to strengthen the EU’s AML and Countering the Financing of Terrorism (“CTF”) framework. If enacted, this proposal would create a new regulatory body and standardize AML/CTF regulations across the EU and replace the current AML regime which varies across individual nations. The new AML/CTF Authority would have supervisory powers including over selected obliged entities of the financial sector such as crypto-asset service providers and would also be responsible for the monitoring, analysis, and exchange of information concerning money laundering and terrorist financing. With the increasing anonymity provided by cryptocurrency, including through mixers such as Tornado Cash discussed above, the EU’s standardization of a comprehensive AML/CTF regime provides legitimacy to this asset class.
BVI Business Companies Act of 2004. On January 1, 2023, several amendments to the British Virgin Islands (“BVI”) Business Company Act of 2004 relating to voluntary liquidators of solvent BVI business companies will go into effect. Specifically, the amendment requires a voluntary liquidator to be a resident of the BVI (unless a joint voluntary liquidator is a BVI resident) that has at least 2 years of liquidation experience, is competent to perform the liquidation, and is familiar with relevant legislation. Further, voluntary liquidators will now be required to maintain the entity’s accounting records and to provide them to the entity’s registered agent
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Compliance Calendar
As you plan your regulatory compliance timeline for the coming months, please keep the following dates in mind:
December 12, 2022
- Annual Renewal Payments Due for Preliminary Statement Issued in E-bill for Registration/Notice Filings. Payment can be made through FINRA Firm Gateway in the E-bill tab.
December 16, 2022
- Cayman Islands FATCA and CRS reporting deadlines.
December 22, 2022
- Last day to submit form filings via IARD prior to year-end. CRD/IARD will be unavailable to submit any filings from 11 PM ET, December 22, 2022 through January 2, 2023, due to year-end renewal processing.
December 31, 2022
- Review RAUM to determine 2022 Form PF filing requirement.
- Registered CPOs must submit a pool quarterly report (CPO-PQR).
- Cayman funds regulated by CIMA that intend to de-register (i.e. wind down or continue as an exempted fund) should do so before this date to avoid 2022 CIMA fees.
January 10, 2023
- Form 13H Quarterly Filing for Changes. Filing is for calendar quarter that ended December 31, 2022 and should be submitted within 10 days of quarter end.
January 15, 2023
- Quarterly Form PF due for Large Liquidity Fund Advisers (if applicable).
January 31, 2023
February 14, 2023
- Form 13F Quarterly Filing for Changes. Filing is for Calendar Quarter that ended December 31, 2022 and should generally be submitted within 45 days of quarter end.
- Form 13H Annual Filing for Calendar Year that ended December 31, 2022.
- Form 13G Annual Filing for Calendar Year that ended December 31, 2022.
March 1, 2023
- Quarterly Form PF due for larger hedge fund advisers (if applicable).
- Deadline for annual affirmation of NFA/CFTC exemptions. Exemptions must be affirmed within 60 days of Calendar Year end or exemptions will be withdrawn by the NFA.
March 31, 2023
- Form ADV Annual Update Amendment. Deadline to update and file Form ADV Parts 1, 2A, 2B (and Form CRS, if applicable).
March 31, 2023
- Cayman Islands CRS Compliance Form deadline.
Periodic
- Fund Managers should perform “Bad Actor” certifications annually.
- Form D and Blue Sky Filings should be current.
- CPO/CTA Annual Questionnaires must be submitted annually, and promptly upon material information changes, through 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, David Rothschild, Scott Kitchens, Tony Wise, Alex Yastremski, & Garret Filler
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.