Regulation A+ for Token Offerings

Overview of Regulation A+ for Token Sponsors

Token issuers have come under increasing scrutiny with respect to their offerings on the heels of various statements by SEC personnel (see here, here and here). SEC representatives have testified recently before House and Senate committees that the initial coin offerings (“ICOs”) they have seen are securities offerings and that it is “hard to have an [ICO] without a securities offering.” These statements along with recent SEC enforcement actions against ICOs have created the desire for token issuers to make their offerings SEC compliant. Many token issuers have thus begun to offer and issue tokens through certain exemptions from the securities registration regime including Regulation D private offerings and the Simple Agreement for Future Tokens (“SAFT”). One option many groups are looking into is using Regulation A+ (“Reg. A+”) to offer security tokens publicly.

Background

Regulation A was overhauled through the JOBS Act, resulting in what is now referred to as Regulation A+. Reg. A+ allows for a registered security to go through a general solicitation process without going through the long and costly IPO process. Securities issued under Reg. A+ can be freely traded, subject to some restrictions and holding periods. Another unique feature is that it allows for “testing the waters,” soliciting investors to gauge interest in the offering before or after filing the offering statement. To qualify to use Reg. A+, an issuer must have their principal place of business in the United States or Canada and not be an ineligible investor (please see our blog post Notes on Regulation A+ for more information).

Reg. A+ has two tiers; Tier 1 allows issuers to raise up to $20 million and Tier 2 allows issuers to raise up to $50 million over a 12-month rolling period.[1] Below is a side-by-side comparison of the two tiers.

Tier 1 and Tier 2 Comparison

Tier 1

Can raise up to $20 million
No limit on amount investor can purchase
All types of investors (qualified purchasers, accredited investors, and unaccredited investors)
2,000 investor limit pursuant to Section 12(g) of the ’34 Act
Do not need audited financial statements except in special circumstances
Must comply with state “blue sky” laws regarding securities registration

Tier 2

Can raise up to $50 million
Limits on how much an unaccredited investor can purchase (see below)
All types of investors (qualified purchasers, accredited investors, and unaccredited investors)
Conditional exemption from Section 12(g) of the ’34 Act restrictions[2]
Audited financial statements
State “blue sky” laws regarding securities registration are preempted
Must file annual, semi-annual, and current event reports after the offering with the SEC

Process

The process will look something like the following:

Step 1: Entity Formation
- To start the process, the entity must first be created. This includes putting together the articles of incorporation and operating agreement, registering the entity with the state(s) in which it will operate, drafting promissory note distribution agreements (a SAFT can be used here instead), and issuing securities.
Step 2: Draft Form 1-A
- There are three parts to Form 1-A: Part I: Notification Filing, Part II: Offering Circular, and Part III: Exhibits.
- Part I: Notification Filing
  - This is a brief summary of information about the issuer, offering, and jurisdictional information. It can be filled out online and is formatted like the Form D filing. It requires information such as balance sheet financials, determination of eligibility, a summary of the offering, and designation of the jurisdiction.
- Part II: Offering Circular
  - The offering circular is a simplified and scaled down version for the Form S-1 and is similar to hedge fund offering documents. It is the primary disclosure document prepared in connection with the Reg. A+ offering. This section requires information such as risk factors, the business plan, plan of distribution, Management’s Discussion & Analysis (“MD&A”) of Financial Condition and Results of Operations, management interests, and detailed analysis of the securities being offered.
- Part III: Exhibits
  - The exhibit that are required as part of the Form 1-A include:
  - Issuer formation documents (e., operating agreement, articles of incorporation, etc.)
  - Promissory note agreement (or SAFT)
  - Agreement between issuer and broker-dealer
  - Opinion from legal counsel
  - Consent of auditor
  - Testing the waters materials
  - Escrow agreement (if necessary)
Step 3: Submission to the SEC
- Once all the materials for the Form 1-A are assembled, the Form 1-A will be filed for qualification on the SEC’s Electronic Data Gathering, Analysis, and Retrieval (“EDGAR”) system. Issuers can request that their offering statement be non-public as long as they are publicly filed no later than 21 calendar days before qualification. Once Form 1-A has been submitted, the issuer will correspond with the SEC regarding the submission to ensure that it is complete. The offering statement on Form 1-A only needs to be qualified by order of the SEC and issuers will receive a notice of qualification from the Division of Corporation Finance. With the consent of the Director of the Division of Corporation Finance, issuers are allowed to withdraw an offering statement so long as none of the securities under it have been sold and the offering statemen is not subject to a temporary order suspending the Regulation A exemption.
Step 4: Notice Filing
- For this step, the issuer will need to determine in which states to concentrate their selling efforts. Once the states have been selected, the issuer will need to conduct the required notice filings in each state. Although Tier 2 offerings preempt state securities registration and qualification provisions, state securities regulators can still require issuers to file any documents that were with the SEC with state with state securities regulators.
Step 5: Ongoing Compliance
- Tier 2 issuers are required to file Form 1-K, Form 1-SA, and Form 1-U with the SEC.
  - Form 1-K is an annual report that is filed 120 days after the fiscal year end. It consists of two parts: part 1 contain basic fillable information; part 2 requires the following: business operations of the issuer; transactions with related persons; information about directors, executives, and significant employees; MD&A; and two years of audited financials.
  - Form 1-SA is a semiannual report which is filed 90 days after end of first 6 months of fiscal year. It does not require an audit and includes financial statements and MD&A.
  - Form 1-U needs to be filed within 4 business days of any of the following:
    - Fundamental changes in the nature of the business;
    - Bankruptcy or receivership;
    - Material modification of the rights of security holders;
    - Changes in the certifying accountant of the issuer;
    - Non-reliance on previous financial statements or a related audit report or completed interim review;
    - Changes in control of the issuer;
    - Departures of the principal executive officer, principal financial officer or principal accounting officer; or
    - Unregistered sales of 10 percent or more of outstanding equity securities.
Final Step: Exit Reporting
- Tier 1 issuers are required to file an exit report on Form 1-Z through EDGAR no later than 30 calendar days after the termination or completion of an offering.
- Tier 2 issuers may file an exit report on Form 1-Z if the offering has fewer than 300 security holders of record, offers and sales are not ongoing, and the issuer is up to date on all filings required by Regulation A.

Timeline

The timeline for a Reg. A+ offering will look something like the following:

Week 1: The initial discussion of terms and the offering will take place. The issuer and their legal counsel will create a detailed legal and operational timeline.
Week 2: The issuer will form the necessary entities, start drafting Form 1-A, and begin gathering the needed financials statements and other documents.
Week 3-4: All documents and financials will be finalized and submitted to the SEC.
Week 5: The issuer will begin the notice filing process and conduct the necessary ongoing compliance.
Week 6 and on: The issuer will begin back and forth discussion process with the SEC regarding the offering.

Issues & Other Items to Consider

There are a few items to consider when choosing to register under the Regulation A exemption:

Testing the Waters – If testing the waters occurs after filing the offering statement, any solicitation materials used must be preceded or accompanied by a preliminary offering circular or contain a notice informing potential investors where and how the most current preliminary offering circular can be obtained. These solicitation materials must also be included as an exhibit when the offering statement is submitted for nonpublic review or filed.
Tier 2 Unaccredited Investor Limit – In a Tier 2 offering, an unaccredited investor can purchase no more than: (a) 10% of the greater of annual income or net worth (for natural persons); or (b) 10% of the greater of annual revenue or net assets at fiscal year end (for non-natural persons).
Auditing – Tier 2 issuers will need to have their financial statements audited and should begin this process as soon as possible. However, if a Tier 1 issuer has had previously audited financial statements, in certain cases they may need to submit these.
Solicitation through Electronic Communication – An issuer is allowed to “test the waters” through platforms that limit the number of characters or text that can be included and still satisfy the requirements of Rule 255 if: (a) the electronic communication is distributed through a platform that limits the number of characters or text that may be included in the communication; (b) including the required Rule 255 statements together with the other information would cause the communication to exceed the platform’s characters or text limit; and (c) the communication contains an active hyperlink to the required Rule 255 statements and prominently conveys important or required information through the hyperlink. However, if an electronic communication can contain the Rule 255 statements in their entirety along with the other information without exceeding the platform’s characters or text limit, it is not appropriate to only include hyperlink to the required statements.
Payment for Securities – For both tiers, an issuer can accept payment for the sales of its securities only after its offering material have been qualified by the SEC. In addition, issuers under Tier 1 offerings generally must have their offering materials qualified by state securities regulators in each state in which it plans to sell securities.
Secondary Sales – For the 12 months following its first offering, no more than 30% of the aggregate offering price may be sold by security holders. After the 12 months, secondary sales by affiliates will be subject to the 30% limit over a 12-month period. Secondary sales by non-affiliates at this point will only be curtailed by the maximum offering allowed under each tier.

Conclusion

Thus far, Reg. A+ provides the most flexibility for SEC compliant ICOs. Although there are reporting obligations and other restrictions, Reg. A+ allows for what is essentially a “mini-IPO” without the cumbersome process. As token issuers look to be compliant, we are likely to see an uptick in Reg. A+ offerings.

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Bart Mallon is a founding partner of Cole-Frieman & Mallon LLP. Cole-Frieman & Mallon LLP has been instrumental in structuring the launches of some of the first digital currency-focused hedge funds and works routinely on matters affecting the digital asset industry. Bart can be reached directly at 415-868-5345.

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[1] This rolling 12-month period means that each month you will need to recalculate the aggregate sales, dropping off the sales from more than 12 months ago. For example, if an offering pursuant to Reg. A+ started in January of 2018, it means that by February of 2019 initial sale of securities from January 2018 are no longer in the aggregate total (thus only calculating February 2018 – February 2019 sales).

[2] As long as the issuer remains current with their periodic reporting, engages the services of a transfer agent registered with the SEC pursuant to Section 17A of the Exchange Act, and meets the size-based requirements similar to those of a “smaller reporting company” under the Securities Act and the Exchange Act.

Airdrops and Securities Laws

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Legal Issues Surrounding Digital Asset Airdrops

Given the regulatory scrutiny on initial coin offerings, many digital asset company sponsors (those launching an ICO token/product/security/utility/etc) have been looking for ways to get their assets in the hands of a large number of people to begin creating network effects so the digital asset become valuable. One way to accomplish this is through an “airdrop” where the sponsor gives away the digital asset to certain persons under certain circumstances. Airdrops come in many shapes and forms – in some, the sponsor deposits only the digital asset they have created and in others a sponsor or other third party might deposit a variety of digital assets created by different groups. Some airdrops require users to do something (sign up for a list or tweet a link related to the sponsor) and some are done for “free”. In any event, there are potentially securities laws issues related to the airdrops and any transactions in the digital asset after the airdrop. The below analysis is intended as a broad overview, but each airdrop should be considered in light of its facts and circumstances. Additionally, the regulation of airdrops, including how they may be taxed, is beginning to evolve and subject to change.

Potential Application of Securities Laws to Airdrops

The legal status of digital assets is uncertain and continually developing – whether a token is a security ultimately depends on the particulars of each token. Given recent statements by the SEC, however, it is safest to assume that any airdropped tokens are securities. The public offering or sales of securities must be registered with the SEC or qualify for an exemption, though many token companies are not complying with these requirements. As a result, a number of these airdrops may be violating securities laws, even if the teams behind the assets claim they are not securities, or if they do not realize their activities fall within the scope of the securities laws. In light of this, the following legal issues may apply to an airdrop:

Transfer Restrictions – Even if a token qualifies for an exemption from registration with the SEC, it may be subject to transfer restrictions. For example, many securities are exempt from SEC registration via the private placement exemption under Regulation D (also known as “Reg D”), which requires a certain holding period (e.g. 6-12 months) before a purchaser can transfer the securities. While the Reg D exemption applies to purchases and sales of securities, the Reg D holding restrictions may apply because the SEC may view the exchange of personal information and/or public promotion as payment. In light of this, the recipients of digital assets (unknowingly) may be restricted from transferring those assets and should be careful.
Free Stock Enforcement Actions – In the late 1990’s the SEC brought enforcement actions in cases of “free stock” offerings. In such instances, companies gave out “free” stock in exchange for something of value to the company. For example, recipients provided personal information, solicited additional investors, and linked to issuers’ websites. The SEC was concerned that investors were not receiving full and fair disclosures about the securities. Airdrops resemble free stock since the airdrop teams give “free” tokens, often in exchange for information like email addresses or social media shares. Additionally, these airdrop programs are often promoted in mediums such as Telegram chats where disclosures are entirely absent. Because of these similarities with free stock, the SEC could bring enforcement actions against the sponsors of the airdrops in the future.
Broker-Dealer Regulations – Generally, a broker is anyone that engages in securities transactions on behalf of another person for compensation, and must be registered with the SEC. If a team airdrops digital assets on behalf of other token companies, it could be deemed a broker if it receives compensation for the airdrop. This compensation could take the form of tokens or marketing services from issuers of the airdropped assets.
Underwriter Liability – An underwriter is someone that acts on behalf of a securities issuer, for example, by distributing securities of the issuer. Depending on the circumstances, underwriters can be liable for an issuer’s securities violations. If an airdrop team deposits tokens that are issued by another company, it could also be liable for the securities violations of that company, which very well may be the case, as described above.
Pump & Dump – Pump and dump schemes occur when an organized group coordinates to artificially change the price of an asset. The SEC and CFTC have issued warnings about token pump and dump schemes, and the SEC has already pursued certain groups for these schemes. In light of this, airdrop announcements and marketing materials will likely be subject to heightened scrutiny by the SEC and CFTC.
KYC/AML – Know Your Customer (“KYC”) and Anti-Money Laundering (“AML”) laws are aimed at combatting money laundering and bribery and require certain due diligence on clients. KYC and AML regulations typically apply to banks, broker-dealers, FINRA members, and other financial institutions, as well as large cash transactions. Many token exchanges already implement KYC and AML procedures, for example, by requiring new users to upload a driver’s license in order to prove their identities. It’s possible that an airdrop team may be subject to KYC and AML requirements such that it would need to verify the identity of each recipient.

Conclusion

As the digital asset industry becomes more aware of the securities laws and the nuances of the application of those laws to the digital asset space, sponsors of digital assets are working to make sure their business plan and token distribution structure fit within the laws. While airdrops (“free tokens”) seem like one way to get around certain securities laws, there are still risks and sponsors should vet any potential distribution, even if free, with legal counsel. We do expect to see a wider variety of token offering structures used in the future, including Regulation A+ which has fewer restrictions on securities transfers.

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Alternative Trading Systems (ATS)

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ATS Registration Overview for Digital Asset Platforms

Digital asset platforms located in the U.S. that facilitate trading and exchange of digital assets (which are deemed to be securities) are generally subject to securities laws requiring such platforms to be registered as a national securities exchange (“NSE”) or fall within an exemption from NSE registration. One exemption from registration as an NSE allows firms to conduct a platform business if such firm is registered as an alternative trading system (“ATS”). This requirement was first highlighted by the SEC in the DAO Report released in July 2017. We anticipate that many digital asset platforms currently facilitating trading will continue to face scrutiny as to whether they need to be registered as NSEs or an ATS and many have already begun the process to register as an ATS.

ATS Definition & Requirement to Register

The statutory definition of an ATS is:

any organization, association, person, group of persons, or system:

(1) That constitutes, maintains, or provides a market place or facilities for bringing together purchasers and sellers of securities or for otherwise performing with respect to securities the functions commonly performed by a stock exchange within the meaning of § 240.3b-16 of this chapter; and

(2) That does not:

(i) Set rules governing the conduct of subscribers other than the conduct of such subscribers’ trading on such organization, association, person, group of persons, or system; or

(ii) Discipline subscribers other than by exclusion from trading.

As many digital asset platforms or exchanges technically fall within the ATS definition, these platforms will need to appropriately register with the SEC. To register as an ATS, the platform will need to do the following:

Register as (or buy) a broker-dealer
File Form ATS
Comply with Regulation ATS

1. Register as a Broker-Dealer

Registering as a broker-dealer (“BD”) is a pre-requite to becoming an ATS. A firm may only file Form ATS with the SEC after receiving the Financial Industry Regulatory Authority’s (“FINRA”) approval of its broker-dealer application (or after purchase of a broker-dealer). For platforms registering as a broker-dealer, at a high level the firm must:

Submit Form BD;
Comply with all applicable state requirements; and
Ensure all of its “associates persons” (BD representatives) have satisfied applicable qualification requirements.

The process to register as a new BD is well worn and relatively straight forward. Firms applying to register as a BD will need to submit online through Form BD online and then submit a New Membership Application (“NMA”) to FINRA. The NMA requires the firm to describe their business and compliance policies and controls in detail. A firm will also be subject to an in-person new membership interview and will have to demonstrate how the ATS technology operates to FINRA staff. As part of the BD process, the firm will need to become a member of at least one self-regulatory organization (“SRO”), which is likely to be FINRA, and become a member of the Securities Investor Protection Corporation (“SIPC”).

If a firm is already a broker-dealer (or has a broker dealer affiliate) but is not an ATS, the firm will need to submit a Continuing Membership Application (“Form CMA”) to FINRA. For groups registering as a de novo BD, the firm should describe those parts of its business that will include the ATS function. As with a de novo BD, an existing BD must demonstrate to FINRA staff how the ATS technology operates.

2. File Form ATS

After a firm has registered as a BD and has discussed the ATS platform with FINRA (to FINRA’s satisfaction), the firm will need to notify the SEC that it is operating as an ATS. Form ATS is the official SEC notification and must be submitted at least 20 days before the firm begins to operate its platform.

Form ATS is general in scope and requires information such as:

Certain identification information (i.e. full name, business name, address, CRD number, etc.)
Firm incorporation documents as attachments
Description of the types of users on the platform (i.e., broker-dealer, institution, or retail) and any differences in access to services between such users
List of the types of securities (digital assets/tokens which are deemed to be securities) that will be traded on the platform
Description of how the ATS will operate
Description of certain ATS operational procedures (i.e., entry of orders, transaction executions, reporting transactions, compliance, etc.)

It is important to note that Form ATS is a notice filing where the SEC provides no confirmation to the ATS regarding the filing status unless the form is deficient. When a Form ATS has been filed with the SEC, it will be listed on the SEC website which will display the platform’s full name, the name(s) under which business is conducted, and the city and state of the ATS. The reports on Form ATS are generally not published and are considered confidential. Such reports will only be available to the SEC staff, state securities authorities, and any SRO for examination.

3. Ongoing Compliance

An ATS will be subject to numerous compliance obligations outside. Some of the specific ATS obligations include:

File Form ATS-R (which summarizes the ATS’s transactions, on a quarterly basis) within 30 calendar days after the end of each quarter.
Amend Form ATS at least 20 calendar days before implementing a material change to the operation of the ATS.
Update Form ATS within 30 calendar days after the end of each quarter to correct any inaccurate or unreported information.
Permit the examination and inspection of its premises, systems, and records and cooperate with the examination, inspection, or investigation of subscribers by the SEC or SRO of which such subscriber is a member.

Additional BD, FINRA, and other guidelines, regulations, and obligations include:

Participating in the lost and stolen securities program.
Complying with the fingerprinting requirement.
Maintaining and reporting information regarding affiliates.
Following certain guidelines when using electronic media to deliver information.
Maintaining an anti-money laundering program.
Complying with the Department of Treasury’s Office of Foreign Assets Control (“OFAC”) programs.
Filing quarterly and annual financial statements to the SEC.

If an ATS is not in compliance with the above requirements it may be subject to steep penalties. In addition, it is important to note that securities on a registered ATS platform may be subject to a wide range of holding periods which must be enforced for an ATS to remain in compliance.

Registration Timing

It is unclear exactly how long a particular ATS application will take to be approved – it will largely depend on the exact scope of activities the platform will be involved with. In general a platform designed for trading of private placements (in a kind of closed system for accredited investors) would likely take anywhere from 6-12 months to become fully licensed after submitting the Form NMA. Technically, FINRA is required to review and process a substantially complete NMA within 180 calendar days after receiving it.

Issues to Consider

There are a number of issues to consider with respect to an ATS application.

Underlying Instruments – the securities on most current digital asset exchanges are unregistered securities which were originally offered outside of any sort of registration exemption. Essentially these are restricted securities and any person selling or reselling such securities are arguably violating US securities laws (for more background, please see our post on restricted securities and distribution structures). In such a case, we are not sure how FINRA will view a platform which facilitates the trading of restricted instruments. We have seen many token issuers over the last 6-12 months who have decided to offer their tokens/securities according to registration exemptions, including through SAFTs. To the extent a digital asset platform only transacts with such tokens (or tokens which go through the S-1 IPO process, which we think will happen within the next 12 months), we believe it is likely that such a platform would be able to be registered with FINRA.
Discussion with FINRA Regarding Trading System – we have not talked directly with FINRA about their review of ATS platforms. Most ATS platforms were created to allow for “dark pool” trading in the traditional institutional securities space. It is unclear if FINRA has the experience or technical understanding (currently) to deal with digital assets and applicable trading platforms.
IRS Reporting Requirements – the IRS released a notice in 2014 regarding the tax treatment of virtual currency. Since then, the IRS has subjected exchanges to certain user reporting requirements. It is unclear whether the IRS will extend these types of user reporting requirements to ATS platforms as well.
FinCEN’s Money Services Businesses Requirements – the Department of the Treasury’s Financial Crimes Enforcement Network (“FinCEN”) released guidance in March of 2013 regarding individuals who handle virtual currencies. FinCEN determined that a person engaged as a business in the exchange of virtual currency for real currency, funds, or other virtual currency (an “exchanger”) is subject to money services business (“MSB”) registration. Although it is unclear if an ATS qualifies as a MSB, FinCEN has taken action against virtual currency exchanges that did not register with the bureau.
Anti-Money Laundering and Know Your Customer Requirements – MSBs are required by the Bank Secrecy Act to have Anti-Money Laundering (“AML”) and Know Your Customer (“KYC”) procedures. AML procedures are required to detect and report suspicious actives that may indicate money laundering and terrorist financing. KYC procedures are identification verification actions taken to ensure that the user is truly who they claim to be in order to prevent fraud.
State Regulations – many states have imposed their own laws regarding digital assets. In addition, each state has its own rules and regulations regarding ATS platforms that operate within the state. Before beginning to operate an ATS, you will want to research what rules and regulations your state has imposed.

Conclusion

After the DAO report, there have been a number of recent comments from SEC officials regarding digital assets and trading platforms that show the need for the cryptocurrency industry to quickly begin the process of integrating into the traditional securities regulatory landscape. We believe that the ATS structure will become the predominant structure for digital asset exchanges in the future. We also believe that over the next 12-24 months, as regulators flesh out various issues, the process will become more streamlined and well worn. A few cryptocurrency related platforms have already started the process to become an ATS, with more likely to follow.

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Token Distribution and Unregistered/Restricted Securities

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Digital Assets and Restricted Securities Background

Many recent Initial Coin Offerings (ICOs) and other token sales are being conducted through a Simple Agreement for Future Tokens (SAFT) or other private placement that exempts the token from registration as a security with the SEC. Tokens sold through these structures have become hot investments, and access to deals selling these tokens is generally difficult to obtain. Accordingly, many investors are creating private funds, unincorporated investment groups, syndicates or other types of investment-fund-like structures (“syndicates” or “investors” for the purposes of this post) to invest in these tokens or SAFTs. Many times these syndicates are established with the stated intent or objective to make distributions of the tokens immediately upon receipt. Effectively the sponsors of such structures have created a de-facto distribution system for VC like investments into blockchain projects. The question is how such a distribution structure fits with traditional securities regulations – specifically, can privately placed tokens (securities) be distributed shortly after receipt? The answer is probably no.

Background on Unregistered Securities

SAFTs, tokens from a SAFT, or other private placements are in most cases going to be unregistered securities (unless the token or instrument later becomes registered with the SEC which is highly unlikely). In general federal securities laws prohibit the transfer of unregistered securities unless an exemption applies to the transfer. Any person then who has possession of, and then transfers, an unregistered security without complying with an applicable exemption is breaking the securities laws and subject to civil penalty (fine, rescission, bar from industry, etc). Additionally, many private placements and SAFTs contain contractual provisions that restrict transfer of tokens for a certain amount of time after issuance (with a wink and a nod from the token issuer that “everyone transfers them anyways”). Unless there is an exemption allowing for the transfer of the tokens (restricted securities), the transferor would be both breaking securities laws and breaching contractual representations made to the token sponsor.

Potential Exemptions

Section 4(a)(1)

Given the above framework, investors or syndicates will want to find an exemption so they can transfer the tokens in accordance with securities laws (the risk posed by breaching a contractual representation to the token sponsor is beyond the scope of this post). Among statutory exemptions, Section 4(a)(1) the Securities Act of 1933 (the “Securities Act”) provides an exemption from registration of the securities if the sales/transaction is not conducted by an issuer, dealer, or underwriter. These terms all have precise definitions, but in this context we would be most concerned about the transferor being deemed an “underwriter” which is defined, in part, as “any person who has purchased from an issuer with a view to, or offers or sells for an issuer in connection with, the distribution of any security, or participates or has a direct or indirect participation in any such undertaking.” This is a broad definition, and because of the stated or not-stated intent of creating a distribution structure for tokens, the syndicates described above may well be considered “underwriters” in this context and need to find another exemption on which to rely.

Investors my be in luck though as there are two other common exemptions that may be available – Rule 144 and Section 4(a)(1 ½).

Rule 144

Rule 144 of the Securities Act allows public resale of restricted securities if certain conditions are met. The central condition is that the unregistered securities are held by the investor for a period of at least one year. Further, the transferor/investor may not be an affiliate of the issuer. There may be reduced holding period requirements if the issuer is subject to the Exchange Act Reporting requirements, but this is not a likely scenario in the digital asset space. We believe for most syndicate groups, Rule 144 is the best way to comply with the transfer restriction. Of course, certain syndicates operating in this space might want or need to distribute the tokens before the expiration of Rule 144’s one-year holding period, and while imperfect as a solution, Section 4(a)(1 ½) (discussed below) may grant another option.

Section 4(a)(1 ½)

As mentioned above, Section 4(a)(1) of the Securities Act provides an exemption from registration for transactions by any person other than an issuer, underwriter, or dealer. Section 4(a)(2) of the Securities Act provides a separate exemption for transactions by an issuer through a private offering. Over time, through case law and acknowledged by the Securities and Exchange Commission (the “SEC”), the “Section 4(a)(1 ½)” exemption was created. This exemption generally is an exemption for private offerings, similar to Section 4(a)(2), but for entities that are not issuers.

To avoid being deemed an underwriter (and to ensure that a resale is sufficiently private), the investor/transferor must be able to show that it did not purchase the restricted securities with a view to distribution or resale. In order to show this the investor/transferor should examine the following criteria :

Number of Purchasers – there should be a limited number of purchasers of the restricted security. This generally can be satisfied if there are less than 25 purchasers.
Investment Intent – the investing entity’s intent in purchasing the tokens or SAFT should be to hold for an indefinite period of time and not with a view to resell or distribute. The longer the investing entity holds the tokens or SAFT, the better the argument for the investor/transferor’s original intent. Generally, in conjunction with other facts and circumstances, holding the security for at least six months will evidence the investor/transferor’s investment intent. The investor/transferor should also obtain a representation from purchasers that (1) the purchase is being made as an investment and not for resale and (2) any subsequent transfer will be made only in an SEC-registered transaction or in compliance with an exemption from registration.
Offeree Qualification – the investor/transferor of the token or SAFT should determine whether the buyer can hold the securities for an indefinite period of time and assume the risk of the investment by looking to the experience and sophistication of the buyer.
Information – the investor/transferor should provide access to all information about the investment and business of the issuer that would be necessary to the buyer. The investor/transferor should also provide access to any nonpublic information if it is an insider with such information.
Private Offering – No form of general advertising or general solicitation may be used in reselling the securities.

Because of the facts and circumstances determination for Section 4(a)(1 ½), the safest approach to addressing these restricted securities’ holding periods is for the investor/transferor to hold the securities for greater than one year in order to fall under the Rule 144 safe harbor.

Other Issues to Consider

There are a number of additional items that should be considered in the context of transferred digital assets that may have been issued as private securities:

Securities v. Non-Securities. The restricted securities transfer rules apply to securities – they do not apply to non-security instruments. Entities that invest in tokens and SAFTs may want to consider taking a position that the tokens are not securities and therefore not subject to securities laws. Such a position would entail a facts and circumstances determination, and taking such a position is likely a risky strategy based on recent comments from SEC Chairman Clayton. Also, taking the position that a SAFT is not a security would be problematic if the SAFT included language that it was a restricted security or otherwise contained a restrictive legend.
Distribution to syndicate owners. If an entity wants to distribute the tokens or a SAFT instrument to its underlying owners, it should be aware that the above exemptions do not apply to a distribution to a syndicate’s underlying owners. Additionally, the SEC would likely consider an in-kind distribution of tokens in exchange for redemption of interests in a syndicate as consideration sufficient to constitute a sale.
Regulation S. Non-US investors may consider investing in a SAFT or purchasing tokens under Regulation S of the US securities laws. While such investors would be non-US investors, Regulation S contains a one-year holding period similar to Rule 144 for sales to US persons so resale of such instruments would potentially be limited.
Timing. No official guidance has been issued regarding holding periods and SAFT instruments. We do not know whether the holding period begins when a SAFT is issued or once the actual tokens are issued (i.e. whether the SAFT and tokens are separate securities). In cases where tokens are issued after a significant period of time following the SAFT execution, this determination may be significant. Again, a determination one way or another will require a facts and circumstances analysis.

Conclusion

Investors should be aware that SAFTs and tokens in which they invest may be restricted securities that may not be resold absent an applicable exemption. With respect to digital assets, this issue is nascent and evolving, but investment managers should be cognizant to follow the securities laws in the absence of additional guidance from the SEC. Please reach out if you have questions on any of the above.

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Notes on Regulation A+

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Last week members from our firm attended the inaugural Reg A Conference in New York, where various industry participants gathered to discuss Regulation A under the Securities Act of 1933 (Reg A+). The conference covered a wide range of topics on the Reg A+ landscape, including the recent shift towards utilizing Reg A+ for initial coin / security token offerings (more on this below).

As background, Reg A+ is a securities exemption created by Title IV of the JOBS Act that allows issuers to conduct securities offerings of up to (i) $20 million for Tier 1 offerings or (ii) $50 million for Tier 2 offerings on an annual basis. Reg A+ is viewed by some as a “mini-IPO” that provides small issuers with a more affordable and expedited method of publicly selling securities to retail investors throughout the United States.

Regulatory Obligations

While Reg A+ may be an attractive option for many startup and emerging companies, there are some notable eligibility restrictions. Only issuers that have a principal place of business in the United States or Canada may conduct a Reg A+ offering. Additionally, Reg A+ is not available to:

Companies subject to the Securities Exchange Act of 1934;
Investment Companies;
Business Development Companies;
Blank Check Companies;
Certain Bad Actors;
Issuers of fractional undivided interests in oil or gas rights or a similar interest in other mineral rights; and
Issuers disqualified due to filing deficiencies.

Issuers that are eligible to issue securities under Reg A+ must undergo a review process with the SEC and potentially state securities regulators. Tier 1 issuers must qualify with state securities regulators as well as the SEC. Tier 2 issuers must qualify offerings solely with the SEC, as state review is preempted for Tier 2 (although state notice filings may be required). Tier 2 issuers must also provide audited financials as part of the qualification process.

Issuers that do qualify and issue securities pursuant to Reg A+ are also required to maintain post-qualification filings. Tier 1 issuers must file a Form 1-Z after the termination of an offering, whereas Tier 2 issuers must file annual audited financials, semi-annual unaudited reports, and current reports for ongoing offerings.

Why Regulation A+?

The primary selling point of Reg A+ is that it provides an expedited path for startup and emerging companies to issue securities to retail investors. Unlike private placements under Rule 506(b) or Rule 506(c) of Regulation D, securities offered pursuant to Reg A+ are purchasable by retail investors and freely tradeable upon issuance. Furthermore, while Rule 506(b) offerings institute a prohibition on general solicitation and registered offerings enforce a quiet period, issuers offering securities pursuant to Reg A+ may freely advertise before, during, and after the qualification period (subject to certain disclosure and disclaimer requirements).

Equity offerings pursuant to Reg A+ can also be listed on a registered exchange, with many issuers opting to do so. In short, Reg A+ effectively bridges the gap between Regulation D private placements and registered securities offerings by providing issuers access to the broader retail market and exchanges without the commitment and expense of conducting a registered offering.

Application for Initial Coin Offerings

There has been much discussion of late regarding the best mechanism for digital asset issuers to conduct initial coin offerings (ICOs) that are compliant with United States securities laws. While there has been some evidence that certain digital assets—namely Bitcoin and Ethereum—are likely not securities, there is strong evidence that the SEC considers most ICOs unregistered securities offerings.

In what is seen as the SEC’s initial assertion of jurisdiction in the digital asset and cryptocurrency economy, the SEC has repeatedly stated that ICO issuers must register offers or sales of securities unless a valid exemption applies. This has led many to believe that the SEC was signaling that token offerings could be offered pursuant to existing securities rules and exemptions. This belief was further solidified when SEC Commissioner Jay Clayton plainly stated: “It is possible to conduct an ICO without triggering the SEC’s registration requirements. For example, just as with a Regulation D exempt offering to raise capital for the manufacturing of a physical product, an initial coin offering that is a security can be structured so that it qualifies for an applicable exemption from the registration requirements.”

With these statements and policies in mind, we believe that an increasing number of token issuers will look to conduct security token offerings (STOs) pursuant to Reg A+. Currently, multiple entities are working to register with the SEC and FINRA as broker-dealers and/or alternative trading systems capable of listing STOs and brokering related transactions. If STOs gain popularity as an alternative method to raise capital and/or securitize interests in assets, Reg A+ is the natural landing spot for tokenized securities—it is the most practical exemption that allows issuers to access retail investors and list the tokenized securities on exchanges without going through a full registration.

Conclusion

Although Reg A+ has only been in existence for three years (Reg A+ became effective in June 2015), it appears to be gaining traction as a preferred method for raising capital. While it can be challenging to determine the exact amount of capital that issuers have raised due to staggered and less frequent reporting timeframes, the SEC’s Office of Small Business Policy disclosed that Reg A+ offerings raised approximately $600 million from June 2015 through September 2017. Industry professionals estimate that number is now closer to $1 billion in the three years since the establishment of Reg A+.

In March of this year, the U.S. House of Representative passed the Regulation A+ Improvement Act of 2017, which would increase the cap on Tier 2 Regulation A+ offerings to $75 million. If the legislation passes the Senate and is signed into law, the increased cap could potentially provide tailwinds for further proliferation of Reg A+ as a funding mechanism for startup and emerging companies.

Please feel free to reach out to us if you have any questions about this post or if you believe your company could benefit from issuing equity, debt, or digital assets pursuant to Reg A+.

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Kevin Cott is a partner of Cole-Frieman & Mallon LLP. Cole-Frieman & Mallon LLP has been instrumental in structuring the launches of some of the first digital currency-focused hedge funds. For more information on this topic, please contact Mr. Cott directly at 770-674-8481.

General Data Protection Regulation (GDPR)

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Overview of GDPR for US Private Fund Managers

The General Data Protection Regulation (“GDPR”) is a new set of requirements intended to strengthen the protection of citizens’ personal data as well as data movement within the European Union (“EU”). GDPR was adopted on May 24, 2016 by the European Parliament and the Council of the European Union and went into effect on May 25, 2018. The regulation replaces Directive 95/46/EC, known as the Data Protection Directive and may apply to certain organizations (including private fund managers) in the US who work with persons in the EU. This post is designed to give fund managers an overview of the regime and some initial items that should be considered.

What is GDPR?

GDPR sets restrictions on those who process, transfer, or monitor personal data and the procedures by which this is done. The term “personal data” means any information relating to an identified or identifiable natural person. The term generally means any information that directly or indirectly can lead to the identification number, location data, online identifier, or similar items related to the identity of a natural person (can include physical, physiological, genetic, mental, economic, cultural, social data, etc). Organizations that are subject to GDPR but are not compliant can be fined the greater of €20 million or 4% of global annual turnover. GDPR requires that any personal data breach must be reported within 72 hours and justification must be given for any delays.

One of the key aspects of GDPR is that it requires organizations to appoint a Data Protection Officer (DPO) in the following three situations: (1) if the organization is processing public data as a public authority; (2) the organization’s processing operations require regular and systematic monitoring of data subjects on a large scale; and (3) the organization has large scale processing of personal data relating to criminal convictions or special categories that reveal identity of a natural person (including physical, physiological, genetic, etc.). Although private fund managers may not fall into any of the above categories, it is encouraged under Article 29 Data Protection Working Party (“WP29”) for organizations to appoint a DPO as part of good practice procedures and to demonstrate compliance with GDPR.

Who is regulated?

The requirements of GDPR applies to controllers (the person(s) or entity that determines the purposes and means of processing personal data) or processors (the person(s) or entity that processes personal data on the controller’s behalf) of personal data. It also applies to the processing activities related to offering goods or services to the data subjects from the EU or monitoring behaviors that take place within the EU.

*** Practically, for private fund managers, GDPR is applicable if you have European investors in a fund or actively solicit or market to European investors.

What are the initial steps a private fund manager should take?

Depending on the scope of activity, we believe that managers should think about implementing a full GDPR compliance program. In the meantime, managers subject to the directive should take immediate actions:

Send a disclosure statement to EU investors regarding GDPR and the fund’s obligations under GDPR.
Attach the disclosure statement regarding GDPR to the fund subscription documents moving forward to ensure that all new investors receive it.
Update the fund’s offering documents with a GDPR disclosure.
Amend agreements with service providers who processes EU investors’ personal data on the fund’s behalf.
Determine whether the fund needs to establish an EU Representative.

How do you create a GDPR compliance program?

Managers with data subject to GDPR will need to take inventory of their data which is covered by the regulation and should create certain procedures and controls with respect to the data. We believe that initial steps should include the following:

Create a list of all types of personal information your fund holds, the source of that information, with whom you share it, what you do with it and how long you will keep it.
Create a list of places where your fund keeps personal information and the ways data flows between them.
Create a publicly accessible privacy policy, which includes a lawful basis to explain why the fund needs to process personal information, that outlines all processes related to personal data.
Appoint a Data Protection Officer (DPO) if necessary.
Create awareness among decision makers about GDPR guidelines.
Review and/or update the fund’s security technology that is used to process personal data (i.e. firewalls, security verification tools, etc.).
Update e-mail security to reduce the risk of phishing and other attacks on protected information.
Create a compliance program that includes staff training on data protection items.
Create a list of third parties that process personal data for you and update your privacy policy to disclose your use of these third parties.
Put a contract in place with any data processors with whom you share data containing explicit instructions for the storage or processing of data by the processor.

Conclusion

Managers should begin this process of exploring the impact of GDPR on their operations immediately if they have not already done so. Managers should also consult with offshore counsel, compliance consultants, and/or GDPR specialists for guidance on how to best comply with GDPR to meet the fund’s particular needs. GDPR has radically changed how personal data is processed in the EU and abroad. The sooner a manager enacts GDPR compliant policies, the sooner the manager can cater to EU citizens and the less likely it will be subject to penalties.

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Bart Mallon is a founding partner of Cole-Frieman & Mallon LLP. Cole-Frieman & Mallon LLP has is a leader in the hedge fund space and routinely works with managers on legal, regulatory and compliance issues. If there are any questions on this post, please contact Mr. Mallon directly at 415-868-5345.

CoinAlts Fund Symposium East – New York, April 19th

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Cryptocurrency Fund Conference Sponsored by Cole-Frieman & Mallon

As we have recently announced in our firm’s first quarter legal update, we are one of the founding sponsors of the second CoinAlts Fund Symposium which will be held in Midtown Manhattan on April 19^th. The agenda for the day is as follows:

Opening Remarks by Cory Johnson of Ripple
Legal & Regulatory Panel featuring Bart Mallon (moderator) and Karl Cole-Frieman (panelist)
Industry Keynote by Mark Yusko of Morgan Creek Capital Management
Featured Keynote by John Burbank of Passport Capital
Best Practices in Tax, Accounting and Operations
Trading & Execution in Digital Assets
Allocators to Digital Asset Funds
Cryptocurrency Trends and Innovations featuring Laura Shin (moderator) and Marco Santori (panelist)

The event is preceeded by a networking event for women in the blockchain/digital asset space on Wednesday evening sponsored by CoinAlts and Circle. Attendance at the main event is expected at around 400 people and will include digital asset managers, investors, students and service providers.

For more information on the event please see the CoinAlts East press release.

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For more information on this topics related to the digital asset space, please see our collection of cryptocurrency fund legal and operational posts.

Bart Mallon is a founding partner of Cole-Frieman & Mallon LLP. Cole-Frieman & Mallon LLP has been instrumental in structuring the launches of some of the first cryptocurrency focused hedge funds. If there are any questions on this post, please contact Mr. Mallon directly at 415-868-5345.

CoinAlts East Announced – April 19, 2018 (Press Release)

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Below is the press release on our CoinAlts East event. We hope to see you there.

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CoinAlts Fund Symposium Announces East Coast Event

NEW YORK (PRWEB) MARCH 30, 2018

The CoinAlts Fund Symposium is announcing its second event, called CoinAlts East, in New York on April 19, 2018. The event will be headlined by the keynote speaker John Burbank of Passport Capital in a fireside chat format. Mark Yusko of Morgan Creek Capital Management will be the featured industry speaker. Additional speakers include Cory Johnson of Ripple and Donald R. Wilson of DRW. The all-day conference will address issues that digital asset managers face on the legal and regulatory front, as well as issues related operation items, trading and fund raising from institutional investors.

“We are so fortunate to have such high-quality speakers and panelists. Our goal has always been to foster a community of the best minds in the crypto space and I think you see that in both our speaker list and the attendees of the conference,” said conference co-chair Bart Mallon of the law firm Cole-Frieman & Mallon LLP. CoinAlts East comes on the heels of the first full day conference for digital asset managers held in September in San Francisco and attended by over 400 industry professionals. CoinAlts East is expected to sell 500 tickets to the all-day event.

“The first CoinAlts event had such an overwhelmingly positive response that we knew we needed to bring the event to New York. The asset class is maturing and traditional investment managers are beginning to be very much involved in the space,” said Corey McLaughlin of Cohen & Company, one of the conference’s founding sponsors. Lauren Colonna of Ovis Creative, a marketing and consulting firm and sponsor of CoinAlts East, echoed Corey’s comments saying that “in addition to the standard alternative asset management work we continually see, we are experiencing a significant increase in the demand for institutional quality marketing materials and messaging for managers in the cryptocurrency and digital asset space.”

Current early bird pricing for investment managers is $500 per person and $750 per person for service providers. Early bird pricing ends on March 30, 2018, after which the price will be $750 and $1,000 respectively. The conference is also the sponsor of a Women in Crypto networking event which will be held on April 18, 2018.

About the CoinAlts Fund Symposium

The CoinAlts Fund Symposium was established by four firms with significant practices devoted to fund managers in the cryptocurrency and digital asset space. Cohen & Company specializes in the alternative investment industry and advises cryptocurrency funds on important tax, audit and operational matters. Harneys Westwood & Reigels LLP is a leading international offshore law firm that advisers fund managers on all aspects of the life of a Cayman or BVI fund including formation, restructuring and closure. MG Stover & Co. is a full service fund administration firm built by former auditors and fund operators to deliver world class solutions to the global alternative investment industry. Cole-Frieman & Mallon LLP is a premier boutique investment management law firm, providing top-tier, responsive and cost-effective legal solutions for cryptocurrency fund managers.

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Bart Mallon is a founding partner of Cole-Frieman & Mallon LLP. Cole-Frieman & Mallon LLP has been instrumental in structuring the launches of some of the first cryptocurrency focused hedge funds. For more information on this topic, please contact Mr. Mallon directly at 415-868-5345.

Cole-Frieman & Mallon 2018 First Quarter Update

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

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April 5, 2018

Clients, Friends, Associates:

The first quarter of 2018 has seen many developments impacting traditional hedge fund managers as well as those in the digital asset space. We enter the second quarter with many topics worthy of discussion, including a number of important regulatory issues currently on the horizon. Below, is our short overview of some of these items.

Before we begin though we’d like to quickly provide a couple of significant updates on Cole-Frieman & Mallon LLP. Effective January 1, 2018 we are delighted to announce that David C. Rothschild has been promoted to partner and welcome Kevin Cott as head of our Atlanta office following the merger of Cott Law Group, P.C. with our firm.

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CoinAlts East

CFM is a founding sponsor of the one-day symposium for digital asset managers in New York on April 19, 2018. The CoinAlts East Fund Symposium will feature a number of panelists (including Bart Mallon and Karl Cole-Frieman) with expertise in the legal and operational aspects of running a digital asset strategy. Keynote speakers are John Burbank of Passport Capital and Mark Yusko of Morgan Creek Capital Management, with opening remarks from Corey Johnson of Ripple and closing remarks by Don Wilson of DRW. The inaugural symposium, held in September in San Francisco, sold out with more than 450 attendees.

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SEC Matters

SEC Published Examination Priorities for 2018. The SEC announced its Examination Priorities for 2018, with a continued focus on examining matters of importance to retail investors, particularly risks to elderly and retiring investors. Specifically, the SEC will focus on: (i) disclosure and calculation of fees and other compensation, robo-advisers and other automated electronic investment advice platforms, never-examined investment advisers and exchange-traded funds, services offered to investors with retirement accounts, and regulatory compliance of advisers and broker-dealers in the cryptocurrency and initial coin offering (ICO) space; (ii) compliance and risk in critical market infrastructure, including clearing agencies, national securities exchanges, transfer agents, and Regulation Systems Compliance and Integrity (SCI) entities; (iii) FINRA and MSRB; (iii) cybersecurity; and (iv) anti-money laundering programs.

SEC Chairman Testifies on The Roles of the SEC and CFTC Concerning Virtual Currencies. On February 6, 2018, SEC Chairman Jay Clayton offered testimony to the Senate Committee on Banking, Housing, and Urban Affairs about the role of the SEC and CFTC in the regulation of cryptocurrencies, ICOs and related activities. Chairman Clayton expressed his support for new technological innovations in the financial markets, while emphasizing that these innovations should not be made at the expense of protecting investors and markets. The Chairman reaffirmed that whenever securities are bought and sold, investors are entitled to the protections and benefits of state and federal securities laws.

The Chairman also stressed that ICOs should be viewed in the context of securities laws and that many ICOs claiming to be “utility tokens” may be securities, notwithstanding labels or the provision of some utility. Further, the Chairman stated most ICOs to date that he has seen have been offers and sales of securities. As a sign of the SEC’s commitment to this policy, Clayton pointed to the establishment of a new cyber unit focused on misconduct involving ICOs and distributed ledger technology, and enforcement actions initiated against fraudulent ICOs.

SEC Staff Letter on Digital Asset Funds. On January 18, 2018, Dalia Blass, the Director of Investment Management at the SEC, published a staff letter addressing issues the SEC has identified for registered funds and products focused on cryptocurrency. While the letter does not address private funds, it outlines various questions addressing how cryptocurrency funds would satisfy the securities laws. The key concerns outlined in the letter include:

Uncertainty around valuation of cryptocurrencies;
Ensuring liquidity for fund investors;
Ability to satisfy custody requirements given the lack of qualified custodians;
Compliance by ETFs given market volatility; and
Potential manipulation of cryptocurrency markets.

In light of the questions and uncertainties identified, the letter expresses the belief that cryptocurrency funds should withdraw registration statements.

SEC Action against Initial Coin Offering. On January 30, 2018, the SEC obtained a court order for an immediate asset freeze to halt an allegedly fraudulent ICO targeting retail investors and claiming to be the world’s first “decentralized bank”. The complaint alleges among other violations, the ICO was an illegal offering of securities and the sponsors made multiple false and misleading statements, including that its customers could be covered under federal deposit protections due to its purchase of a bank. The SEC is seeking preliminary and permanent injunctions, disgorgement of ill-gotten gains plus interest and penalties, and bars against the two co-founders to prohibit them from serving as officers or directors of a public company or offering digital securities again in the future. This SEC complaint highlights the SEC’s increased vigilance in pursuing securities violations in the cryptocurrency and ICO space.

SEC Statement on Unregistered Digital Asset Exchanges. On March 7, 2018, the SEC released a public statement affirming its view that platforms that trade securities and operate as exchanges must register as a national securities exchange or operate under an exemption from registration. This announcement reflects the SEC’s growing interest in online virtual currency trading platforms. The public statement offers advice to investors about how to stay safe while investing on these platforms. Additionally, the statement lists considerations for market participants operating online trading platforms and encourages those market participants to consult with legal counsel and contact SEC staff for assistance in analyzing and applying the federal securities laws.

CFTC Matters

CFTC Issues Virtual Currency Pump-and-Dump Customer Protection Advisory. On February 15, 2018 the CFTC issued its first Customer Protection Advisory focused on virtual currency, specifically warning against “pump-and-dump” schemes. As described in the advisory, pump-and-dump schemes are coordinated online efforts to artificially drive up demand for a virtual currency then quickly sell. In the advisory, the CFTC asserted its general anti-fraud and manipulation enforcement authority over virtual currency cash markets as a commodity. The CFTC advises all customers to only purchase virtual currency or tokens after thorough research.

District Judge Agrees with CFTC Jurisdiction Over Virtual Currencies. On March 6, 2018, a district court judge in the eastern district of New York found that the CFTC has standing in a case related to virtual currency fraud. The judge agreed with the CFTC that virtual currencies can be regulated as a commodity, despite other regulatory agencies asserting jurisdiction over virtual currencies in some cases. The judge also agreed the CFTC’s jurisdiction can be justifiably expanded into spot trade commodity fraud, beyond the classic “futures” contracts for commodities traditionally focused on by the CFTC. The court granted the CFTC a preliminary injunction against the defendants as the case continues.

CFTC Launches Virtual Currency Resource Web Page. The CFTC launched its own resource dedicated to virtual currency, designed to provide information to the public regarding possible risks involved with investing or speculating in virtual currencies. It includes a primer on virtual currency, tips to avoid fraud, a podcast that includes CFTC staff discussing virtual currencies, and other reference sources relating to the CFTC and virtual currency.

FINRA Matters

FINRA Published Regulatory and Examination Priorities Letter for 2018. Similar to the SEC, the Financial Industry Regulatory Authority, Inc. (“FINRA”) recently published its 2018 Regulatory and Examination Priorities Letter, outlining the organization’s enforcement priorities for the current year. FINRA’s specific focus areas for 2018 will include: (i) fraud, particularly microcap fraud schemes that target senior investors; (ii) hiring and supervisory practices for high-risk firms and brokers; (iii) cybersecurity; (iv) anti-money laundering; (v) sales practices and product suitability for specific investors, including the supervisory, compliance, and operational infrastructure firms have put in place with respect to ICOs; and (vi) investor protections related to market manipulation. We recommend that you speak with your firm’s outside counsel and service providers to learn more about these specific priorities and review your firm’s compliance with the applicable regulations.

Other Digital Asset Matters

We have detailed some of the major digital asset regulatory releases for the first quarter of this year in a separate post. In addition to this information, there are some other items of note below.

U.S. Deputy Secretary of Treasury Provides Testimony On Financial Threats. On January 17, 2018, the U.S. Deputy Secretary of Treasury, Sigal Mandelker, testified before the Senate Committee on Banking, Housing, and Urban Affairs regarding a litany of financial threats to national security as well as the U.S. and global financial systems. Among the threats mentioned were emerging technologies including virtual currency. Mandelker emphasized FinCEN’s global focus on ensuring virtual currency providers and exchangers improve compliance activities. Mandelker’s testimony further evidences governmental agencies’ increasing focus on virtual currencies.

Proposed Virtual Currency Regulations Introduced in Hawaii and Nebraska. Multiple bills proposing to regulate cryptocurrency have been introduced in Hawaii and Nebraska. In Hawaii, one proposal defines virtual currency and exempts virtual currency money transmitters from the state requirement to possess reserves to cover all outstanding customer investments. A second proposal in Hawaii requires certain persons engaging the exchange, transfer, or storage of virtual currency in the state to be licensed. The proposal also outlines various other requirements for such a licensee, including the requirement to provide extensive personal information. Additionally, proposals in Hawaii, Connecticut, and Nebraska have been introduced to adopt the Uniform Regulation of Virtual-Currency Businesses Act (URVCBA) developed by the Uniform Law Commission (ULC), which provides a three-tiered structure for registration and licensing.

In Wyoming, multiple bills were passed related to virtual currency. A law was passed that exempts virtual currency from the Wyoming Money Transmitter Act. The Wyoming legislature also passed a law that specifies criteria by which an issuer of virtual currency will not be deemed an issuer of a security in Wyoming. Another law was also passed in Wyoming that exempts virtual currency from Wyoming property tax.

President issues executive order on Venezuela’s Digital Currency. On March 19, 2018, the President of the United States issued an executive order prohibiting transactions by United States persons or within the United States related to any digital currency issued by the Venezuelan government on or after January 9, 2018. This order was made in response the Venezuelan’s government’s issuance of a digital currency in an attempt to avoid United States sanctions. The order also provides that no prior notice is necessary for this order given the ability to transfer assets instantaneously.

Other Items

Fifth Circuit Vacates DOL Fiduciary Rule. On March 15, 2018, the Fifth Circuit Court of Appeals issued a judgment vacating the Department of Labor Fiduciary Rule in its entirety, which we discussed in an earlier update. The Fiduciary Rule expanded the definition of a “fiduciary” to include anyone making a securities or investment property “recommendation” to an employee benefit plan or retirement account. The rule also included a Best Interest Contract (“BIC”) Exemption, which permits investment advisers to retail retirement investors to continue their current fee practices, including receiving variable compensation, without violating prohibited transactions rules, subject to certain safeguards. The Court vacated the rule, finding that the Department of Labor lacked the authority to enact the rule under ERISA. The Court stated, in part, that Congress did not intend to expand the definition of fiduciary in passing ERISA in 1974. Just days earlier, the Tenth Circuit upheld a portion of the Fiduciary Rule, opening up additional uncertainty about the rule and inviting the Supreme Court to provide clarification.

CIMA Releases Guidance Notes for changes to its AML regulations. The Cayman Islands Monetary Authority (CIMA) has released guidance notes on its 2017 revisions to its Anti-Money Laundering Regulations, which were discussed in our previous quarterly update. The new guidance, in part, provides details of the requirements when compliance under the revisions are outsourced or delegated. If you have any questions, we recommend that you reach out to your administrator or oﬀshore counsel.

Supreme Court Narrows Dodd-Frank Whistleblower Protection. On February 21, 2018, in a unanimous decision, the Supreme Court of the United States held in Digital Realty Trust, Inc. v. Somers, that the anti-retaliation provision of the 2010 Dodd-Frank Act covers only individuals who have reported a violation of the securities laws to the SEC. The Dodd-Frank Act does not protect individuals who only report violations internally. This ruling does not affect the anti-retaliation provisions of the Sarbanes-Oxley Act which protects whistleblowers who report certain types of misconduct internally in public companies.

IRS Clarifies Carried Interest Taxation Regulation. On December 22, 2017, Congress passed the Tax Reform Act which, among other items, alters the taxation of carried interest. Under section 1061 of the Act, carried interest must be held for at least three years in order to recognize long-term capital gains on the distribution of that interest. Section 1061 provides an exception for partnership interests held by a corporation.

On March 1, 2018, the Internal Revenue Service and Department of the Treasury issued Notice 2018-18 announcing their intent to issue regulations providing guidance for section 1061 of the Internal Revenue Code. Specifically, the guidance would exclude “S corporations” from the definition of a “corporation” as applied to carried interest taxation. This guidance will be applied retroactively and is effective for taxable years beginning after December 31, 2017. Managers should discuss further implications with their tax advisor and legal counsel.

Supreme Court Narrows Scope of Bankruptcy Code Securities Clawback Safe Harbor. In a unanimous opinion, the United States Supreme Court narrowed the scope of transactions qualifying for protection under section 546(e) of the Bankruptcy Code. This provision generally provides an exception that disallows a bankruptcy trustee from recovering a settlement payment made by a financial institution in connection with a securities contract. The court’s ruling means that such exception will not apply when the financial institution acts only as an intermediary.

SEC Encourages Self-Reporting of Share Class Selection Disclosures. The SEC announced its Share Class Selection Disclosure Initiative (SCSD Initiative) which encourages investment advisers to self-report securities violations with respect to failure to make disclosures concerning mutual fund share class selection. Investment advisers are required to disclose the conflict of interest that arises when an adviser receives 12b-1 fees for a share class when a less expensive share class is available for the same fund. Generally, qualifying settlements with the SEC will require the adviser to return profits on the transaction to the harmed clients, but not impose any further monetary penalties. For those advisers that do not take advantage of the initiative, the SEC is still focused on violations associated with mutual fund share class selection.

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

Deadline – Filing

March 31, 2018 – Deadline to update and file Form ADV Parts 1, 2A & 2B
April 10, 2018 – Amendment to Form 13H due if necessary
April 16, 2018 – 1st Quarter 2018 Form PF filing for quarterly filers (Large Liquidity Fund Advisers)
April 30, 2018 – Collect quarterly reports from access persons for their personal securities transactions
April 30, 2018 – Distribute code of ethics and compliance manuals to employees. Require acknowledgement form to be executed in connection with such delivery
April 30, 2018 – Annual Privacy Notice sent to all clients or fund investors (for Advisers with Fiscal Year ending December 31)
April 30, 2018 – Distribute audited financial statements to investors (most private fund managers, including SEC, state and CFTC registrants)
April 30, 2018 – Distribute Form ADV Part 2 to clients
April 30, 2018 – Quarterly NAV Report (registered commodity pool operators claiming the 4.7 exemption)
April 30, 2018 – 2017 Annual Form PF due date for annual filers (Large Private Equity Fund Advisers and Smaller Private Fund Advisers)
May 15, 2018 – Quarterly Commodity Trading Advisor Form PR filing
May 15, 2018 – File Form 13F for first quarter 2018
May 31, 2018 – First deadline for Cayman Islands Financial Institutions to submit their CRS returns to the Cayman Islands Tax Authority
May 31, 2018 – Third reporting deadline (full reporting) for Cayman Islands Financial Institutions with reporting obligations under the Cayman FATCA regulatory framework to report their U.S. Reportable Accounts to the Cayman Islands Tax Authority
June 30, 2018 – Distribute audited financial statements to investors (private fund managers to funds of funds, including SEC, state and CFTC registrants)

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

Digital Asset Regulatory Items 2018 First Quarter

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There have been a number of regulatory updates in the first quarter of the year in the digital asset space. Below we provide an overview of these items.

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SEC Matters

Speeches

Chairman’s Testimony on Virtual Currencies: The Roles of the SEC and CFTC
SEC Chairman Jay Clayton
On February 6, 2018, Chairman Jay Clayton offered testimony to the Senate Committee on Banking, Housing, and Urban Affairs about a wide range of issues concerning virtual currencies. Clayton voiced his support of technological innovations, his concern for Main Street investors, and provided a warning that labeling an asset a “utility token” would not in itself prevent it from being deemed a security.

Releases

Statement on Potentially Unlawful Online Platforms for Trading Digital Assets
On March 7, 2018, the SEC released a public statement affirming its view that platforms trading digital assets that meet the definition of securities and operating as exchanges must register as a national securities exchange or operate under an exemption from registration. The public statement lists considerations for market participants operating online trading platforms, encourages those market participants to consult with legal counsel, and to contact SEC staff for assistance in analyzing and applying the federal securities laws.

Regulators Are Looking at Cryptocurrency
In a joint op-ed published in the Wall Street Journal on January 25, 2018, SEC Chairman Jay Clayton and CFTC Chairman J. Christopher Giancarlo affirmed their support of innovative financial technologies but warned investors of the risks of new markets. In order to protect investors, the agencies will continue working to bring “transparency and integrity” to the digital asset markets.

SEC Comments on NASAA’s Release Reminding Investors of Risks in Cryptocurrency Investment:
The SEC commended the January 4, 2018 release from the North American Securities Administrators Association stressing concerns relating to cryptocurrencies and ICOs. The SEC’s statement also reminds investors that there is a substantial risk that SEC efforts will not result in recovery of digital asset investments, despite the fact that the SEC and state securities regulators are pursing violations by ICO promoters.

Staff Letter: Engaging on Fund Innovation and Cryptocurrency-related Holdings
Staff Letter: Engaging on Fund Innovation and Cryptocurrency-related Holdings
Dalia Blass, Director, Division of Investment Management, US Securities and Exchange Commission
In a staff letter to the Investment Company Institute and Asset Management Group, Blass addressed potential issues the SEC has identified concerning registered funds and products focused on cryptocurrency. The letter outlines issues in valuation, liquidity, custody, arbitrage for ETFs, and potential manipulation.

Enforcement

Charges Filed Against Former Bitcoin-Denominated Exchange and Operator
On February 21, 2018, the SEC filed charges against BitFunder and its founder Jon E. Montroll alleging fraud and operating an unregistered securities exchange. According to the complaint, Montroll misappropriated users’ funds and failed to report the theft of more than 6,000 bitcoins as part of a cyberattack.

SEC Suspends Trading in Three Issuers After Questionable Announcements Concerning Digital Assets
On February 15, 2018, the SEC suspended trading in the securities of three companies (Cherubim Interests, Inc., PDX Partners, Inc., Victura Construction Group, Inc.) after the companies made questionable statements about their acquisition of certain cryptocurrency and blockchain technology related assets.

SEC Action against Initial Coin Offering
On January 30, 2018, the SEC obtained a court order for an immediate asset freeze to halt an allegedly fraudulent ICO targeting retail investors and claiming to be the world’s first “decentralized bank.” The complaint alleges that among other violations, the ICO was an illegal offering of securities and that the sponsors made multiple false and misleading statements including that its customers could be covered under federal deposit protections due to its purchase of a bank.

CFTC Matters

Speeches

Testimony of Chairman J. Christopher Giancarlo before the Senate Banking Committee, Washington, D.C.
Christopher Giancarlo
On February 6, 2018, CFTC Chairman J. Christopher Giancarlo offered testimony to the Senate Banking committee concerning virtual currencies. Giancarlo affirmed the commission’s authority to regulate virtual currencies derivatives markets while noting its limited authority to oversee spot virtual currency platforms. Within these parameters, Giancarlo described how the commission has worked toward its goals through enforcement actions, educating investors and market participants, and policy considerations that allow for both innovation and protection.

Keynote Address by Commissioner Brian Quintenz before the DC Blockchain Summit
Brian Quintenz
On March 7, 2018, CFTC Commissioner Brian Quintenz gave the keynote speech at the DC Blockchain Summit, discussing his personal views on digital assets and the role of the CFTC. He discussed the history of the CFTC’s role with respect to digital assets, reminding the audience that “in the derivatives markets, the CFTC has both oversight and enforcement authority, while in the spot markets, or the platforms where commodities themselves are actually bought and sold, the CFTC has only enforcement authority.” He then discussed the future of regulation of digital assets, including possible exploration of “a new, private independent organization [that] could perform an oversight function for U.S. cryptocurrency platforms.”

Releases

CFTC Warns Investors About Virtual Currency Pump-and-Dump Schemes
On February 15, 2018 the CFTC issued its first Customer Protection Advisory focused on virtual currency, specifically warning against “pump-and-dump” schemes. In the advisory, the CFTC asserted its general anti-fraud and manipulation enforcement authority over virtual currency cash markets as a commodity. The CFTC advises all customers to only purchase virtual currency or tokens after thorough research.

CFTC Launches Virtual Currency Resource Web Page
The CFTC launched a virtual currency resource page in its ongoing effort to educate the public about the risks of virtual currencies. The site features an introduction to virtual currencies, consumer advisories, links to relevant CFTC podcasts, and more.

Enforcement

US District Court Issues Preliminary Injunction Order Against Coin Drop Markets
On March 6, 2018, the US District Court of the Eastern District of New York issued a preliminary injunction against Patrick K. McDonnell and CabbageTech, Corp. d/b/a Coin Drop Markets in connection with the CFTC’s continuing litigation concerning fraud and misappropriation of virtual currencies. Under the terms of the injunction, the defendants are prohibited from engaging in fraudulent activities in violation of the Commodity Exchange Act.

CFTC Charges My Big Coin, Inc. with Fraud and Freezes its Operations
On January 16, 2018, the CFTC filed an enforcement action against Mark Gillespie, and My Big Coin Pay, Inc. in connection with an alleged ongoing virtual currency scam. On the same day, the US District Court for the District of Massachusetts granted an order freezing the assets of the defendants.

CFTC Charges Colorado Cryptocurrency Company with Fraud, Halting Alleged Ponzi Scheme
On January 18, 2018, the CFTC filed a civil enforcement action against Dillon Michael Dean and his company, The Entrepreneurs Headquarters Limited. The complaint alleged ongoing fraud, misappropriation of client funds, and failure to register with the CFTC.

State Matters

Wyoming Governor Signs Five Crypto-related Bills into Law

The governor of Wyoming recently signed into law five bills making the state friendlier to digital asset businesses.

HB 19 exempts virtual currency from the Wyoming Money Transmitter Act.
HB 70 provides criteria for which an issuer of virtual currency will not be deemed an issuer of a security in Wyoming.
SF 111 exempts virtual currency from Wyoming property tax.
HB 101 allows for electronic corporate records to be stored through blockchain and provides certain requirements of such systems.
HB 126 authorizes the formation of Series LLCs

Uniform Regulation of Virtual-Currency Businesses Act legislation introduced in several state legislatures
Proposals in Hawaii, Connecticut, and Nebraska have been introduced to adopt the Uniform Regulation of Virtual-Currency Businesses Act (URVCBA) developed by the Uniform Law Commission (ULC), which provides a three-tiered structure for registration and licensing.

Proposed Virtual Currency Regulations Introduced in Hawaii
Multiple bills proposing to regulate cryptocurrency have been introduced in Hawaii. One proposal defines virtual currency and exempts virtual currency money transmitters from the state requirement to possess reserves to cover all outstanding customer investments. A second proposal in Hawaii requires certain persons engaging the exchange, transfer, or storage of virtual currency in the state to be licensed. The proposal also outlines various other requirements for such a licensee, including the requirement to provide extensive personal information.

Proposed Bill in New York would Alter Audit and Licensing Requirements for Crypto-Businesses
A bill has been introduced to the New York Legislature that would change audit and licensing requirements for cryptocurrency related businesses. The bill would prohibit licensing fees targeted at cryptocurrency businesses and establish new audit requirements focusing on security.

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Bart Mallon is a founding partner of Cole-Frieman & Mallon LLP and focuses his legal practice on the investment management industry. He can be reached directly at 415-868-5345

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