Bart Mallon is a founding partner of Cole-Frieman & Mallon LLP. Mr. Mallon can be reached directly at 415-868-5345. |
Blockstack Regulation A+ Token Offering
Overview of the Regulation A+ Offering Circular for Crypto Tokens
By Bart Mallon
Co-Managing Partner, Cole-Frieman & Mallon LLP
It is generally accepted that the initial coin offering (ICO) from mid-2017 is dead and that firms raising money for their blockchain or token projects will need to do so in a way that is compliant with SEC laws and regulations. For many groups, this means raising money through general private placements or various SAFTs (simple agreement for future tokens) and SAFEs (simple agreement for future equity). However, raising money in this manner does not put the seller’s tokens in the hands of a mass audience which is an important element for groups who are trying to obtain network effects for their project. One alternative to traditional private offerings for token projects is the Regulation A+ public offering of tokens for up to $50M in proceeds. Although Regulation A+ has been a potential avenue for a number of blockchain groups, it has been an untested and it was unclear what the time or costs would be to complete such an offering. This all changed with the Blockstack public offering of tokens pursuant to Reg A+.
Through considerable time and cost, Blockstack submitted its Regulation A+ “Tier 2” offering to the SEC for “qualification” to publicly sell its tokens (Stacks Tokens) on April 11 2019. We have reviewed all 203 dense pages of Blockstack’s Offering Circular (which is estimated to cost $1.8M in legal and accounting fees to produce) and take this opportunity to discuss the unique characteristics of the the offering which any token project will need to address in the future. While we can see that this will be the first step in standardizing token offerings under Regulation A+, we also see that there are a number of legal, business and operational issues that any token sponsor will need to address in what will inevitably be a “not as easy as advertised” process with the SEC.
What is Blockstack & the Stacks Token?
Blockstack is a blockchain platform with a goal of “sponsoring and commercializing an open-source peer-to-peer network using blockchain technologies to ultimately build a new network for decentralized applications.” The platform has been designed to do a number of things that current blockchains and centralized working solutions (i.e. Google Docs) do, but with a focus on decentralization and a high level of privacy. Blockstack is introducing use cases which include a browser, universal user accounts and personal data lockers which are all designed to give users control over their personal data. Eventually the blockchain will allow for more decentralized apps and a smart contract platform with a new smart contract language and more clarity on costs for use of the language.
The Stacks Tokens on the Blockstack network, which are being sold in the offering, will ultimately be used as fuel for running the smart contracts on the blockchain (the tokens will be burned). The Stacks Tokens will also be used by consumers as payments for the decentralized applications that will live on the network. Tokens will also be used for polling purposes and other incentives. In general, the platform looks very similar to other smart contract platforms with some technical differences. The project sponsored is Blockstack PBC, a Delaware public benefit corporation, a company with a number of well-healed and well known investors. For more information on the Stacks Token and project as a whole, you can see their sales deck for the token offering.
$50M Regulation A+ Raise
The proceeds from the raise will be generated through two different programs – the cash program and the app-mining program. Together the programs will raise $50M in consideration over the 12 months following the “qualification” of the offering.
Cash Program
In the cash program, there are two different sales prices for the tokens based on whether the tokens are sold in exchange for vouchers (to persons who indicated interest to Blockstack in November and December of 2017) or if they are sold in the general offering. The price is $0.12 per token (up to 215M tokens) for investors who participated in the voucher program and $0.30 (up to 40M tokens, but can be modified to be up to 62M tokens) for investors who participate through the general offering. The total consideration amount from the cash program (vocher and general offerings) will not exceed $38M, but the total amounts are subject to the tokens ultimately distributed through the app mining program, which is variable.
App Mining Program
Blockstack is offering tokens as rewards to certain developers of applications on its blockchain. [Include more here.] These token rewards are being included as part of the Reg A+ offering because they may be deemed to be investment contracts and/or as part of the offering. Pursuant to this program, all gifted tokens will be deemed to be work $0.30 per token for the first three months after the qualification of the offering, and then based on current market prices for the tokens. The idea is that Blockstack is getting consideration in-kind with work provided on its blockchain and is paying for that work with tokens.
Other Aspects of the Offering and Business
There are a number of other interesting legal and business items which were discussed throughout the offering circular. Many of these items are unique to Blockstack’s business, but many will have general applicability to future Reg A+ digital asset offerings.
- Finalizing tokens offered in program – as previously discussed, the total amount of tokens sold through the offering is not set in stone. Directly after the SEC deems the offering “qualified”, Blockstack will finalize the allocation of tokens between the cash and app mining programs. A sale of the tokens will open 28 days after the SEC deems the offering to be “qualified”.
- Tier 2 investor qualification – the offering is a “Tier 2” offering which means both accredited and unaccredited investors will be allowed to invest. Because it is a Tier 2 offering, the unaccredited investors are limited to invest 10% of the greater of annual income or net worth.
- Concurrent Reg S offering – Blockstack is raising additional capital from non-US persons in a concurrent offering. The tokens sold in the Regulation S offering will be subject to a 1 year lockup (investors cannot use during the lockup period) and are being sold at $0.25 per token.
- Tokens subject to a time-lock – for many reasons Blockstack has chosen that the purchased tokens will be introduced to the platform over time, with full distribution of all sold tokens 2 years after the qualification of the offering. Blockstack will release 1/24th of the sold tokens at inception, then will release 1/24th of the sold tokens once a month thereafter (every 4,320 blocks on the bitcoin blockchain).
- No restriction on transfers of tokens – this offering is not of restricted securities (see our earlier post about token distribution issues / restricted securities) and are free usable and tradable (on a registered exchange or ATS) upon release from the time-lock; however, Blockstack believes the Stacks Tokens will not initially trade on any crypto exchanges and this will make it hard to sell the tokens.
- “Cap Table” – there was much information presented about the current token float (the genesis block created 1.32B tokens) and the amount of tokens sold in previous offerings (various private placements and SAFTs). After all the offerings and various distributions, there will be 116M tokens unallocated that Blockstack will control and can utilize however they wish. Many of the issued tokens have been or are being provided to related entities to compensate employees, similar to stock option grants.
- Use of proceeds – as is the case with most all offerings, there is a discussion of how the sponsors will use the cash proceeds from the sale. Blockstack also discusses the use of the cash proceeds under different levels of total subscription (25%, 50%, 75% and 100%).
- Milestones – through a previous funding round, Blockstack was provided with capital if they met certain milestones with respect to the development and adoption of the Blockstack network. While they easily met the first milestone (technical implementation of certain features of the blockchain), it is unclear if they will meet the second milestone (dealing with adoption of the network). They will be required to “return a significant amount of capital that Blockstack currently intends to use in the development of the Blockstack network.” The milestone is 1M verified users by the end of January 2020. Blockstack specifically says that at current growth rates it will not achieve the second milestone.
- Hard Fork from Bitcoin – Blockstack currently runs as a virtual blockchain on the bitcoin network. It will ultimately transition over to its own blockchain when it has a large enough network to maintain security. This will involve a “hard fork” to the Blockstack network and its associated risks.
- Risk Factors – as with any public or private placement, there are attendant risks which are disclosed to potential investors. These include normal investment risks (operations, catastrophic events, etc) and general risks related to digital/crypto (loss of token, irreversible, loss of keys, various hacks, forks, volatility, uncertain tax treatment, etc), however, there were a number of interesting Blockstack specific risks including: risk of not attracting both users and developers to the platform, the time-lock risk, regulatory risk (does not have New York BitLicense, is not a money transmitter or money services business, potential violation of Regulation M with respect to its activities in its own tokens, etc).
Legal Issues Presented
In addition to the description of many of the business issues related to the creation of the blockchain, there are a number of novel legal issues presented and addressed in the offering circular. Below we have identified the most interesting of these issues and have included how Blockstack has addressed them.
- Are the tokens securities? Blockstack believes that the current tokens (non-sufficiently decentralized) are a type of security called an investment contract and are not equity or debt securities:
We do not believe that the Stacks Tokens should be characterized as either debt or equity under the securities laws. We believe that these tokens should currently be characterized as investment contracts. Holders will not receive a right to any repayment of principal or interest, as might be expected under a traditional debt instrument; nor will they receive an interest in the profits or losses of any Blockstack affiliate, any rights to distributions from any Blockstack affiliate, or any legal or contractual right to exercise control over the operations or continued development of any Blockstack affiliate, as might be expected for a traditional equity instrument.
- When will the tokens be “sufficiently decentralized” so they are no longer securities? This is one of the most important questions of the offering and essentially addresses the question of when the SEC will lose jurisdiction over the tokens in the offering and when/how Blockstack can issue, sell or otherwise use the tokens as rewards for certain activity on its blockchain.
The board of directors of Blockstack PBC will be responsible for regularly considering and ultimately determining whether the Stacks Tokens no longer constitute securities issued by us under the federal and state securities laws of the United States. In making this determination, the board will refer to the relevant legal and regulatory standards for such determination in effect at the time of such determination, will consult with legal counsel and will, if possible and appropriate, seek consultation with relevant regulatory authorities including, we expect, the Commission. At the present time, based on the guidance cited above, we expect this determination to turn the SEC’s recent guidance on the application of the test under SEC v. W. J. Howey Co. (the “Howey test”) to digital assets set forth in its release “Framework for ‘Investment Contract’ Analysis of Digital Assets,” and specifically on whether the Blockstack network is sufficiently decentralized, which will, in turn, depend on whether purchasers of Stacks Tokens reasonably expect Blockstack to carry out essential managerial or entrepreneurial efforts, and whether Blockstack retains a degree of power over the governance of the network such that its material non-public information may be of special relevance to the future of the Blockstack network, as compared to other network participants. Under current guidance, Blockstack would expect to take the position that if the answers to these questions are that purchasers do not and Blockstack does not, the Stacks Tokens will no longer constitute a security under the federal and state securities laws of the United States. The board of directors of Blockstack PBC may also assess other criteria for making this determination, including any criteria based on additional guidance we receive from U.S. regulators. …
In the event that the board of directors of Blockstack PBC determines that the Stacks Tokens are no longer a security issued by Blockstack Token LLC, Blockstack will make a public announcement of its determination at least six months prior to taking any actions based on this determination, such as filing an exit report on Form 1-Z terminating its reporting obligations with respect to the Stacks Tokens under Regulation A.
- Are any actors related to Blockstack or its blockchain required to be registered in any way? Here, Blockstack addresses the issue of whether certain actors are required to be transfer or clearing agents because of their relationship to the blockchain and creation or distribution of the tokens:
We have taken the position that Blockstack, the miners on the network, and the network’s blockchain are not required to register as transfer agents, both because the Stacks Tokens are not currently securities registered under Section 12 of the Exchange Act, and because none of the activities Blockstack, the miners, or the blockchain is involved in are described in the definition of a transfer agent. In addition, to the extent that certain activities that meet the definition of a transfer agent are performed automatically on the blockchain, the blockchain is not a “person” that would be required to register. …
We have taken the position that Blockstack, the miners and the blockchain are not clearing agencies under the Exchange Act because the types of activities they engage in are not those described in the definition of a clearing agency. To the extent that these activities occur on the blockchain, the blockchain is not a “person” that would be required to register.
Blockstack has included similar discussions related to questions on whether it or any related actor is an investment company, broker-dealer, money transmitter, money services business, or subject to New York BitLicense requirements. All of these discussions conclude that the way the current blockchain works, and pursuant to the current interpretation of the securities laws, Blockstack and related actors would not be required to register as any of the above. It is possible that the SEC or the various state securities regulators could disagree with conclusions presented in the offering circular.
- Is the Blockstack Network or the browser an ATS? The issue of what actors may be deemed to be an ATS is an open one and will eventually be an important issue when the SEC provides FINRA and the digital asset industry with future guidance. (HFLB note: SEC and FINRA just recently released a joint statement on digital asset custody which we will be reviewing shortly.)
We have taken the position that neither the network nor the Browser should be viewed as an exchange or an ATS because neither will “bring together” anyone by sorting or organizing orders in the Stacks Tokens in a consolidated way or by receiving orders for processing and execution of transactions in the Stacks Tokens. Instead, each proposed transaction involving Stacks Tokens on the network will by individually negotiated and implemented. For example, transactions by users (such as developers or users of Decentralized Applications) will be posted on an individual basis. In addition, we will be the only “seller” of Stacks Tokens when we distribute them as rewards on the network. …
We also take the position that payments on the network and the Browser for services do not involve “orders” of securities, because they are not primarily purchases of securities. Instead, these payments are commercial sales of access to Decentralized Applications or of items bought through in-app purchases.
Conclusion
It is clear that Blockstack has carefully thought through the business and legal issues involved in launching a Regulation A+ capital raise in order to expand a blockchain and token network. While the offering circular provides thoughtful analysis, it also highlights the many unresolved issues that plague the digital asset space. The digital asset industry in the US is starved for clarity on many of these issues and, if this offering is ultimately qualified, it will be a large step forward in solidifying how token sponsors should proceed with capital raises. Blockstack spent a lot of money to produce the offering circular and we must hope that this filing, or a filing similar to this, can become the template for blockchain token projects of the future.
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Bart Mallon is a founding partner of Cole-Frieman & Mallon LLP. Cole-Frieman & Mallon 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. Mallon directly at 415-868-5345.
Bitcoin ETF – Bitwise Asset Management
Cole-Frieman & Mallon Comment Letter to SEC
On June 12, 2019 our law firm submitted a comment letter to the SEC with respect to the Bitwise Bitcoin ETF application. In our comment we stated that we believe it is in the best interest of the bitcoin market that the Bitwise ETF be approved. We made this statement based on our firm’s experience with asset managers generally, and specifically with asset managers in the digital asset space. We also believe that the various Bitwise presentations and research prepared for the staff (here, here, and here) present strong arguments for the approval of the Bitwise ETF.
The Bitwise ETF application was originally submitted to the SEC by the listing Exchange (NYSE Arca) on January 28, 2019 and has subsequently under gone two statutory extensions (see here) as the SEC tries to figure out how they are going to regulate the digital asset industry. Ultimately the SEC will need to make a final decision (accept or reject) by mid-October. The various comment letters (found here) show overall support for the Bitwise ETF and generally implore the SEC to approve the application.
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For more information on this topic, 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 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 LLP Announces New Partner Scott E. Kitchens
Firm Adds New Denver Office to Expand Practice
Cole-Frieman & Mallon LLP, a leading boutique investment management law firm, is pleased to announce Scott Kitchens has joined the firm as a partner. He will be opening the firm’s new Denver office and will focus his practice on advising private funds and investment advisers in relation to structure, formation and ongoing operational needs. Mr. Kitchens previously worked in the investment management practice group of a large international law firm. He has deep ties to the Colorado investment management community and is committed to growing the firm’s local practice.
“I am excited to welcome Scott to the firm and build out the Denver office together” said Karl Cole-Frieman, co-founder of the firm. “We also know that Scott’s reputation in the Denver community is exceptional, and we believe Scott will propel our firm to be the leading investment fund practice in Denver.” Matthew Stover, CEO of Denver based fund administration firm MG Stover & Co. noted that “the alternative fund industry in Colorado is growing and we believe that Cole-Frieman & Mallon will be a strong addition to the community. We also know that Scott will bring great experience to the new office.”
Mr. Kitchens’ background includes notable experience with venture capital, private equity, and similar closed-end fund structures. “I am very excited to join Cole-Frieman & Mallon and launch its Denver office,” said Mr. Kitchens. “I have known the attorneys at the firm for many years and am confident that we will continue our strong expansion in the investment management space.”
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About Cole-Frieman & Mallon LLP
Cole-Frieman & Mallon LLP is a premier boutique investment management law firm, providing top-tier, responsive and cost-effective legal solutions for financial services matters. Headquartered in San Francisco, with offices in Atlanta and Denver, Cole-Frieman & Mallon LLP has an international practice that services both start-up investment managers, as well as multi-billion dollar firms. The firm provides a full complement of legal services to the investment management community, including: hedge fund, private equity fund and venture capital fund formation, adviser registration, counterparty documentation, SEC, CFTC, NFA and FINRA matters, seed deals, hedge fund due diligence, employment and compensation matters, and routine business matters. Cole-Frieman & Mallon LLP is also a recognized leader in the burgeoning cryptocurrency fund formation space. The firm publishes the prominent Hedge Fund Law Blog which focuses on legal issues that impact the hedge fund community. For more information please visit us at: colefrieman.com.
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Bart Mallon is a founding partner of Cole-Frieman & Mallon LLP and the founder/editor of the Hedge Fund Law Blog. Mr. Mallon directly at 415-868-5345.
Crypto Headlines from Week of April 26 – Bitfinex/Tether & SeedInvest
There were two big announcements in the crypto space this week and we anticipate that both will shape the dialogue in crypto circles over the course of the next few months.
NY AG Order re Bitfinex and Tether – the New York Attorney General announced an order requiring Bitfinex to provide certain information on its corporate activities to New York in connection with an investigation into Tether. The central issue is whether Bitfinex used Tether funds to “hide the apparent loss of $850 million dollars of [Bitfinex] co-mingled client and corporate funds.” The order was announced yesterday and sent the entire crypto market down 10%. Bitfinex has released a statement in response to the order saying that Bitfinex and Tether are “financially strong – full stop.” We anticipate this will be a major story over the next couple of weeks.
SeedInvest Receives ATS License – ever since the SEC released the DAO report in July 2017, firms have been trying to secure a broker-dealer with an Alternative Trading System. A broker-dealer with an ATS designation would allow a digital asset trading platform to legally provide an exchange/trading service in the US. SeedInvest (which was recently bought by Circle), through its affiliated broker-dealer SI Securities, just received the ATS designation (see here on page 11 – “The Firm operates an alternative trading system to facilitate the trading of securities previously purchased in private placement transactions through SI Securities.”). The ATS designation in this instance allows the firm to have a trading system/platform for previously issues equity securities (private placements) and not for tokens; however, it is generally viewed that this is the first step toward FINRA ultimately allowing for the ATS designation to apply to a token platform. We will see how this plays out with other platforms in the near future but this is certainly a sign that regulators are moving in the right direction.
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For more information on this topic, 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 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 2019 First Quarter Update
Bart Mallon is a founding partner of Cole-Frieman & Mallon LLP. Mr. Mallon can be reached directly at 415-868-5345. |
Cole-Frieman & Mallon 2018 End of Year Update
Below is our quarterly newsletter. If you would like to be added to our distribution list, please contact us.
Clients, Friends, Associates: As we prepare for a new year, we also reflect on an eventful 2018 that included developments impacting both traditional hedge fund managers as well as those in the digital asset space. Regardless of these developments, year-end administrative upkeep and 2019 planning are always particularly important, especially for general counsels, Chief Compliance Officers (“CCOs”), and key operations personnel. As we head into 2019, we have put together this checklist and update to help managers stay on top of the business and regulatory landscape for the coming year. This update includes the following:
We are also delighted to announce that effective December 22, 2018 our growing San Francisco team will complete their move to expanded premises at 255 California Street, San Francisco, CA 94111. **** |
Annual Compliance & Other Items Annual Privacy Policy Notice. On an annual basis, registered investment advisers (“RIAs”) are required to provide natural person clients with a copy of the firm’s privacy policy if (i) the RIA has disclosed nonpublic personal information other than in the connection with servicing consumer accounts or administering financial products; or (ii) the firm’s privacy policy has changed. The U.S. Securities and Exchange Commission (the “SEC”) has provided a model form and accompanying instructions for firm privacy policies. Annual Compliance Review. On an annual basis, the CCO of an RIA must conduct a review of the adviser’s compliance policies and procedures. This review should be in writing and presented to senior management. We recommend that firms discuss the annual review with their outside counsel or compliance firm, who can provide guidance about the review process as well as a template for the assessment and documentation. Conversations regarding the annual review may raise sensitive matters, and advisers should ensure that these discussions are protected by attorney-client privilege. CCOs may also want to consider additions to the compliance program. 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 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, 2019. This year, because March 31st falls on a Sunday, we recommend filing annual amendments to the Form ADV on Friday, March 29, 2019, and no later than the first business day following the 90-day deadline (Monday, April 1, 2019). 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”. For SEC RIAs to private investment vehicles, a “client” for these purposes means the vehicle(s) managed by the adviser and not the underlying investors. State-registered advisers need to examine their state’s rules to determine who constitutes a “client”. Switching to/from SEC Regulation. SEC RIAs. 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 29, 2019 for most managers) by filing a Form ADV-W. Such managers should consult with legal counsel to determine whether they are required to register or file an exemption from registration in the states in which they conduct business. ERAs. Managers who no longer meet the definition of an ERA will need to apply for registration with the SEC or the relevant state securities authority, if necessary. 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 29, 2019 for most managers, assuming the annual amendment is filed on March 31, 2019). Custody Rule and Annual Audits. SEC RIAs. SEC RIAs must comply with certain 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 by an independent public accountant registered with the Public Company Accounting Oversight Board (“Auditor”). Statements must be sent to investors in the fund within 120 days after the fund’s fiscal year end. Managers should review their custody procedures to ensure compliance with these rules. California RIAs. California RIAs (“CA RIAs”) that manage pooled investment vehicles and are deemed to have custody of client assets are also subject to independent party and surprise examinations. However, similarly to SEC RIAs, CA RIAs can avoid these additional requirements by engaging an Auditor to prepare and distribute audited financial statements to all investors of the fund, and to the Commissioner of the California Department of Business Oversight (“DBO”). 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 client assets. Other State RIAs. Advisers registered in other states should consult with legal counsel about those states’ custody requirements. ERAs. Each state has its own requirements for ERAs. CA ERAs must undergo an annual audit and provide the audit to their investors within 120 days after the end of their fiscal year (April 30, 2019 for most managers). California Minimum Net Worth Requirement and Financial Reports. RIAs with Custody. Every CA RIA that has custody of client funds or securities must maintain at all times a minimum net worth of $35,000, however, the minimum net worth is $10,000 for a CA RIA (i) deemed to have custody solely because it acts as general partner of a limited partnership, or a comparable position for another type of pooled investment vehicle; and (ii) that otherwise complies with the California custody rule described above (such advisers, “GP RIAs”). RIAs with Discretion. Every CA RIA that has discretionary authority over client funds or securities, whether or not they have custody, must maintain at all times a net worth of at least $10,000, and preferably $12,000 to avoid certain reporting requirements. Financial Reports. Every CA RIA that either has custody of, or discretionary authority over, client funds or securities must file an annual financial report with the DBO within 90 days after the adviser’s fiscal year end. The annual financial report must contain a balance sheet, income statement, supporting schedule, and verification form. These financial statements must be audited by an independent certified public accountant or independent public accountant if the adviser has custody of client assets. Annual Re-Certification of CFTC Exemptions. Commodity pool operators (“CPOs”) and commodity trading advisers (“CTAs”) currently relying on certain exemptions from registration with the U.S. Commodity Futures Trading Commission (“CFTC”) are required to re-certify their eligibility within 60 days of the calendar year end. Such CPOs and CTAs will need 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. For more information on Form CPO-PQR, please see our earlier post. 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 corrected promptly, and the corrected version must be distributed promptly to pool participants. Any amended disclosure documents must also be approved by the NFA. Trade Errors. Managers should make sure 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 address 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 (“SMAs”)) 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 acquisition of 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 the SEC’s large trader thresholds (in general, 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 the 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 Form PF. Smaller private advisers (fund managers with less than $1.5 billion in RAUM) must file Form PF annually within 120 days of their fiscal year-end. Larger private advisers (fund managers 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 advisers” 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 on at least an annual basis, 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, fund managers should review their 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 advisers, SEC RIAs, and ERAs (that are required to file a Form ADV) are due on December 17, 2018. 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 widely, so managers should carefully review reporting requirements in the states in which they operate to make sure they are in compliance with the relevant rules. **** 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 Financial Industry Regulatory Authority, Inc. (“FINRA”) Rules 5130 and 5131. Most managers reconfirm investor eligibility via negative confirmation (i.e. investors are informed of their status on file with the manager and are asked to inform the manager of any changes), whereby an investor’s failure to respond operates as consent affirmation of the 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 conversions. 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 so as 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 set forth in a fund’s 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 2018 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 or company has received the investor’s affirmative consent. States may have different rules regarding electronic K-1s and partnerships and companies should check with their counsel whether they may still be required to send state K-1s on paper. Partnerships and companies must also provide each investor with specific disclosures that include a description of the hardware and software necessary to access the electronic K-1s, the length of time that 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, and their applicable officers and directors, 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. If an offering is continuous, delayed, or long-lived, however, issuers must update their factual inquiry periodically through bring-down of representations, questionnaires, and certifications, negative consent letters, periodic re-checking of public databases, and other steps, 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 such update at least annually. U.S. FATCA. Funds should monitor their compliance with the U.S. Foreign Account Tax Compliance Act (“FATCA”). FATCA reports are due to the IRS on March 31, 2019 or September 30, 2019, depending on where the fund is domiciled. 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 FATCA requirements applicable to different jurisdictions, managers should review and confirm the specific 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 Cayman Islands and British Virgin Islands are required to register with the respective jurisdiction’s Tax Information Authority and submit returns to the applicable CRS reporting system by May 31, 2019. Managers to funds domiciled in other jurisdictions should also confirm whether any CRS reporting will be required in such jurisdictions. CRS reporting must be completed with the CRS XML v1.0 or a manual entry form on the Automatic Exchange of Information portal. We recommend managers contact their tax advisors to stay informed of FATCA and CRS requirements and avoid potential penalties. **** Annual Management Company Matters Management Company Expenses. Managers who distribute profits on an annual basis 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 important 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-related matters at the firm. It is not 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. Since 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. Make sure that partnership agreements and operating agreements are appropriately updated to reflect such changes. Insurance. If a manager carries Directors & Officers or other liability insurance, the policy should be reviewed on an annual basis to ensure that the manager has provided notice to the carrier of all actual and potential claims. Newly launched funds should also be added to the policy as appropriate. 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. Managers can take several steps to optimize their 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 (the “Code”); (v) making a Section 475 election under the Code; and (vi) making charitable contributions. Managers should consult legal and tax professionals to evaluate these options. **** Regulatory & Other Items from 2018 SEC Updates. SEC Annual Enforcement Report. On November 2, 2018, the SEC Division of Enforcement published its Annual Report, which highlighted enforcement efforts protecting “main street investors” through initiatives such as the newly-created SEC Retail Strategy Task Force, disclosures of 12b-1 marketing and distribution fees by mutual funds, required cybersecurity disclosures by public companies, and enforcement efforts regarding Initial Coin Offerings (“ICOs”) and digital assets. In 2018, the SEC brought a total of 821 enforcement actions and obtained monetary judgements totaling $3.95 billion, both of which were increases from 2017 figures. CFTC and NFA Updates. NFA Develops New Swaps Proficiency Program and Exam. On June 5, 2018, the NFA announced the creation of a new online proficiency and exam program for swaps. The online program and exam are expected to launch in early 2020, and any associated persons engaging in swaps activities will be required to pass the program and exam. Previously, training and examinations had only been required for associated persons engaging in futures or forex activities. Digital Asset Updates. SEC Settles Charges Against Digital Asset Hedge Fund Management Company. On December 7, 2018, the SEC settled charges against the management company of a digital asset hedge fund for alleged violations of the general solicitation rules. In the settlement agreement, the SEC alleged that the management company violated the general solicitation rules because they did not have substantive and pre-existing relationships with all investors in their fund, offered securities over a website that was accessible to the general public without a password, failed to take reasonable steps to verify accredited investor status, and engaged in general solicitation via online and in person events. In the settlement, the management company agreed to abide by a cease and desist order and to pay a $50,000 civil penalty SEC Settles Charges Against Digital Asset Hedge Fund Manager. On September 11, 2018, the SEC announced the settlement of charges against a digital asset hedge fund and its manager. The charges included failing to register the hedge fund as an investment company, and offering and selling unregistered securities. Settlement terms included a cease and desist order against both the fund and fund manager, censure, and a $200,000 penalty. Notably, this is the first action the SEC has taken against a digital asset fund based on violations of the registration requirements of the Investment Company Act of 1940, as amended (the “Investment Company Act”). SEC Emphasis on ICOs. Throughout 2018, the SEC focused much of its regulatory and enforcement efforts on ICOs. Notable developments included:
NFA Digital Asset Disclosure Rule. On July 20, 2018, the NFA released an Interpretive Notice creating new disclosure requirements for Futures Commission Merchants (FCMs), CPOs, and CTAs engaging in digital asset activities. For more information on this Interpretive Notice, please see our previous post. New York Attorney General Releases Report on Digital Asset Exchanges. On September 18, 2018, the Office of the Attorney General of New York (the “OAG”) released a report summarizing a crypto exchange fact-finding initiative. Based on the digital asset exchanges examined, the OAG outlined three primary areas of concern: potential conflicts of interest, lack of anti-abuse controls, and limited customer fund protection. SEC Settles Charges Against Founder of Digital Asset Exchange. On November 8, 2018, the SEC settled charges against the founder of a digital asset exchange. The SEC took the position that the digital asset exchange qualified as an “exchange” under the Securities Exchange Act of 1934, as amended, and therefore was required to register with the SEC, which it had not done. The founder agreed to settlement terms including $300,000 in disgorgement, $13,000 for pre-trial interest, and a $75,000 penalty. Other Updates. Second Circuit Amends Insider Trading Ruling. On June 25, 2018, the U.S. Court of Appeals for the Second Circuit amended its decision in United States v. Martoma, clarifying tippee liability in insider trading cases. The Second Circuit held that a “meaningfully close personal relationship” is not required for tippee liability, and once again upheld a former portfolio manager’s 2014 conviction for insider trading. For further discussion of the original 2017 decision please see our previous 2017 Third Quarter Update. Fifth Circuit Vacates DOL Fiduciary Rule. On March 15, 2018, the Fifth Circuit Court of Appeals issued a judgement vacating the Department of Labor (“DOL”) Fiduciary Rule in its entirety, finding that the DOL lacked the authority to enact the rule. The Fiduciary Rule would have expanded the definition of a “fiduciary” to include anyone making a securities or investment property “recommendation” to an employee benefit plan or retirement account. For further discussion please see our previous 2018 Second Quarter Update. GDPR and Enhanced Data Protection Requirements Effected. On May 25, 2018, the General Data Protection Regulation (“GDPR”) went into effect as part of the efforts of the European Union (“EU”) to protect personal data. U.S. fund managers with EU resident investors will need to: (i) maintain records of any data processing activities; (ii) obtain EU clients’ affirmative consent to process data; and (iii) provide EU clients with access to the fund’s privacy policy. Managers that have no presence in the EU, but that also have EU resident investors, may be required to appoint an EU local representative. However, such managers may still be excluded from this requirement if they can demonstrate that their data processing is only “occasional”, does not include special categories of EU resident personal data (including criminal) on a large scale, and is unlikely to result in a risk to the rights and freedoms of natural persons. We believe most of our clients generally fall into this exclusion and will not need to appoint an EU representative. For more information on GDPR, including compliance items of particular note for fund managers, please see our earlier post. Section 3(c)(1) of the Investment Company Act Amended. President Trump authorized the Economic Growth, Regulatory Relief, and Consumer Protection Act (“Growth Act”) on May 24, 2018. A portion of the Growth Act amends Section 3(c)(1) of the Investment Company Act by increasing the number of investors allowed in a qualifying venture capital fund from 100 to 250 investors. The Growth Act defines a qualifying venture capital fund as one with less than $10 million in aggregate capital contributions and uncalled committed capital. Qualified Opportunity Zones. The 2017 Tax Cuts and Jobs Act mandated that the IRS create “Qualified Opportunity Zones” (“QOZs”), which are designated low-income areas that will provide certain tax breaks and incentives. Qualified Opportunity Funds (QOFs) that make investments in QOZs may qualify for tax incentives including a tax deferral of capital gains that are re-invested into QOFs and a tax exclusion for capital gains that are reinvested into QOFs and held for ten years. On October 19, the IRS released proposed regulations and guidance notes that provide clarification on how QOFs can receive capital gain tax deferrals if they are located in QOZs. Offshore Updates. The Cayman Islands Monetary Authority (“CIMA”) Provides Anti-Money Laundering (“AML”) Compliance Guidance and Delays the AML Officer Deadline. CIMA released a notice on April 6, 2018 providing guidance on the 2017 revisions to its AML Regulations. The notice discusses the requirement for private funds to appoint an Anti-Money Laundering Compliance Officer (“AMCLO”), Money Laundering Reporting Officer (“MLRO”) and Deputy Money Laundering Reporting Officer (“DMLRO”), and offer guidance on compliance obligations when these duties are outsourced or delegated. Under these new CIMA requirements, investment funds that conduct business in or from the Cayman Islands must appoint individuals to these new AML officer positions. CIMA has delayed certain deadlines for funds that launched prior to June 1, 2018:
Funds formed on or after June 1, 2018 must have appointed the officers (and confirmed such officers through REEFS for registered funds) at launch. If you have any questions, we recommend fund managers discuss AML compliance with offshore counsel and the fund’s administrator. **** |
Compliance Calendar
Compliance Calendar. As you plan your regulatory compliance timeline for the coming months, please keep the following dates in mind:
Bart Mallon is a founding partner of Cole-Frieman & Mallon LLP. Mr. Mallon can be reached directly at 415-868-5345. |
Cole-Frieman & Mallon 2018 Third Quarter Update
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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 – Third Quarter 2018
The third quarter of 2018 saw increased interest from regulators in the digital asset space, as well as enforcement actions. For your convenience, we have provided an overview of key items from the quarter below.
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SEC MATTERS
Enforcement
SEC Charges Digital Asset Hedge Fund Manager
On September 11, the Securities and Exchange Commission (“SEC”) announced the settlement of charges against a digital asset hedge fund and its manager. The charges included misleading investors, offering and selling unregistered securities, and failing to register the hedge fund as an investment company. The manager marketed the fund as the “first regulated crypto asset fund in the United States” and claimed the fund had filed registration statements with the SEC. Based on investments in “digital assets that were investment securities”, the fund was required to register as an investment company with the SEC. However, the fund was not registered and did not meet any exemptions or exclusions from the investment company registration requirements. The settlement included cease-and-desist orders, censure, investor rescission offers, and a $200,000 penalty. This is the first action the SEC has taken against a digital asset fund based on violations of the investment company registration requirements.
SEC Charges ICO Platform for Operating as Unregistered Broker-Dealer
On September 11, the SEC settled charges against an initial coin offering (“ICO”) platform. The business and its principals were charged with failing to register as broker-dealers and selling unregistered securities. This is the SEC’s first charge against an unregistered broker-dealer in the digital asset space following the SEC’s 2017 DAO Report, which cautioned anyone offering or selling digital assets to comply with federal securities laws such as broker-dealer registration requirements. The business agreed to pay $471,000 plus prejudgment interest, and the principals each agreed to a three-year bar from certain investment-related activities and $45,000 in penalties.
SEC Fines and Halts Fraudulent ICO
On August 14, the SEC settled charges related to an ICO. The token issuer was charged with fraud and the sale of unregistered securities after it claimed the proceeds from its ICO would be used to fund oil drilling in California. However, the issuer falsely represented that it had the necessary drilling lease and misled investors about the potential for profit and the prior bankruptcy and criminal history of the issuer’s principal. The settlement included permanent cease and desist orders, a permanent bar from certain investment-related activities, and a $30,000 fine. In light of recent charges like this, fund managers investing in ICOs should ensure they complete adequate due diligence on investment opportunities.
Other
SEC Denies and Delays Bitcoin ETFs
On August 22, the SEC released three separate orders denying nine Bitcoin exchange-traded fund (“ETF”) proposals. These orders followed the SEC’s July 26 denial of another Bitcoin ETF. The SEC’s reasoning in these denials was mainly based on a concern that the price of Bitcoin may be susceptible to manipulation. However, on September 20, the SEC announced that it has begun a formal review for a physically-backed Bitcoin ETF. The acceptance of such an ETF would increase digital asset investment options and has the potential to promote the overall growth of the industry.
SEC Suspends Trading of Swedish Bitcoin Instruments
On September 9, the SEC temporarily suspended trading of two foreign cryptocurrency investment instruments commonly known as the “Swedish Bitcoin ETFs”. The instruments hold Bitcoin on behalf of shareholders and, prior to the suspension, had been tradable in U.S. brokerage accounts. The SEC suspended the ETFs out of a concern for investor confusion, which was likely based on inconsistent representations. The issuers’ broker-dealer applications referred to the instruments as ETFs, other sources characterized them as exchange-traded notes, and the issuers’ offering memoranda described them as “non-equity linked certificates”. With this suspension in mind, fund managers considering investing in novel digital asset instruments should ensure they understand the nature of the instruments.
CFTC MATTERS
Investor Alerts
CFTC Stresses Due Diligence in ICO Investments
On July 16, the Commodities Futures Trading Commission (“CFTC”) published an alert cautioning investors to conduct extensive research before investing in any ICO, especially those that claim to be utility tokens (i.e. non-securities). The alert includes factors that investors should consider before investing in a token offering, such as the potential for forks, mining costs, liquidity, and risk of hacks.
Enforcement
Court Enters Final Order for CFTC Charges Against Crypto Company
On August 23, a New York federal court entered final judgment against a digital asset company based on charges brought by the CFTC. The company claimed that, in exchange for sending digital assets, customers could receive expert crypto trading advice or have the company trade on their behalf. However, no such expert advice or trading services were provided. The company was charged with fraud and the final judgment included a permanent injunction from certain investment-related activities, more than $290,000 in restitution, more than $871,000 in civil penalties, and post-judgment interest.
NFA MATTERS
NFA Requires CPOs and CTAs to Disclose Digital Asset Activity
On July 20, the National Futures Association (“NFA”) released a notice that imposed new disclosure requirements on futures commission merchants, commodity pool operators (“CPOs”), and commodity trading advisers (“CTAs”) engaged in digital asset activity. Specific to CPOs and CTAs, the NFA is now requiring discussion of certain aspects of digital asset investing, such as volatility, liquidity, and cybersecurity, as well as the inclusion of certain standardized disclosures. Additional details are available in our recent blog post.
FINRA MATTERS
FINRA Charges Broker with Fraud and Unlawful Distribution for Token Offering
On September 11, the Financial Industry Regulatory Authority (“FINRA”) charged a broker in connection with a token offering. The broker attempted to raise money through the offering for an allegedly worthless public company and, in the process, misled investors about the company’s operations and finances. The broker is charged with making material misrepresentations, offering and selling unregistered securities, and failing to notify the broker’s firm about the transactions. This is FINRA’s first disciplinary action involving digital assets.
FEDERAL LEGISLATION
Congressional Representative Introduces Crypto-Friendly Bills
On September 21, Minnesota Congressional Representative Tom Emmer announced three crypto-friendly bills. The first bill would codify an overall “light touch, consistent, and simple” approach to digital asset regulation. The second bill would provide a safe harbor for certain businesses that lack control over consumer funds by exempting them from certain regulations, such as money transmitter licensing requirements. Lastly, the third bill would limit fines for taxpayers that failed to fully report forked digital assets until the Internal Revenue Service (“IRS”) provides further guidance on how such forks should be reported.
STATE MATTERS
New York
New York Attorney General Releases Report on Digital Asset Exchanges
On September 18, the Office of the Attorney General of New York (the “OAG”) released a report summarizing a crypto exchange fact-finding initiative. The report outlines three primary areas of concern:
- Conflicts of Interest – Crypto exchanges are exposed to potential conflicts of interest in several ways. For example, exchanges often have additional lines of business (e.g. broker-dealer) that would either be prohibited or carefully monitored in traditional securities contexts. Additionally, employees may have access to non-public information, and may hold and trade digital assets on their employer’s or competitors’ exchanges. Some exchanges also lack standards for determining which tokens are listed, and the possibility that an exchange may take fees for such a listing create a potential conflict of interest.
- Lack of Anti-Abuse Efforts – Digital asset exchanges have not consistently implemented safeguards to protect the integrity of their platforms. Such safeguards include monitoring real-time and past trades, and restricting the use of bots. Additionally, some exchanges engage in proprietary trading (i.e. trading from the exchange’s own account in order to, for example, promote market liquidity) which may expose users to price manipulation or other abuse.
- Limited Customer Funds Protections – Exchanges lack a consistent and transparent approach to auditing the digital assets they hold. Additionally, several exchanges do not have independent audits completed. These shortcomings make it difficult to determine whether crypto exchanges adequately maintain and protect customers’ assets. The OAG also raised concerns over whether exchanges have adequate protection against hacks and maintain sufficient insurance policies.
Digital asset fund managers should keep these concerns in mind and ensure they properly vet exchanges they may utilize.
Court Rules ICO Tokens May Be Subject to Securities Laws
On September 11, the U.S. District Court for the Eastern District of New York ruled that a criminal case brought against the individual behind two ICOs can proceed to trial. The defendant faces conspiracy and securities fraud charges for allegedly making false claims that the tokens sold in the ICOs were backed by real estate and diamonds. The defendant moved to dismiss the case on the grounds that securities laws are too vague to apply to ICOs, and that the issued tokens were not securities. The issue of whether the tokens in question are securities may now ultimately be decided by a jury.
Texas
Texas Issues Emergency Cease and Desists Against Crypto Investment Scheme
On September 18, the Securities Commissioner of Texas (the “Commissioner”) released three orders related to digital asset investment schemes. First, the Commissioner issued a cease and desist order against a mining company that used promotional materials falsely implying third-party endorsements and associations. Second, the Commissioner issued a cease and desist order against a company that solicited investments to develop a biometric token wallet. The business misled investors with a video of former President Barack Obama that falsely implied he was discussing the company. The business also made unsubstantiated claims, for example, that it was backed by “a leading financial institution”. Lastly, the Commissioner issued a cease and desist order against a company that solicited investments for its crypto and forex trading programs. The company told investors they could earn 10x returns, that those returns were guaranteed, and that there was no investment risk. All orders allege that the companies violated securities laws by offering and selling unregistered securities, engaging in fraud, and making materially misleading statements. These orders further highlight the need for fund managers to conduct due diligence on digital asset investment opportunities.
OTHER MATTERS
Statements
Congressional Representatives Urge IRS to Provide Guidance on Cryptocurrency
On September 19, five members of the House of Representatives published a letter urging the IRS to issue updated guidance on digital asset taxation. The last major guidance from the IRS, Notice 2014-21, was issued in March 2014. Since then, the IRS has increased digital asset scrutiny by, for example, requesting transaction records from crypto exchanges and choosing not to provide leniency through a voluntary crypto disclosure program. Such guidance would hopefully resolve some of the tax uncertainties digital asset fund managers currently face.
NASAA Announces Coordinated Digital Asset Investigations
On August 28, the North American Securities Administrators Association (“NASAA”) announced that regulators in the U.S. and Canada are engaged in more than 200 digital asset-related investigations as part of a coordinated NASAA initiative known as “Operation Cryptosweep”. While investigations have focused on suspected securities fraud, regulators have uncovered other violations, such as the offer and sale of unregistered securities. The initiative has resulted in at least 46 enforcement actions related to ICOs or digital asset investment products.
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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. Mr. Mallon can be reached directly at 415-868-5345
CoinAlts Fund Symposium Announces 3rd Conference in San Francisco
Keynote and Panels to focus on Custody and Institutionalization
After two successful events, the CoinAlts Fund Symposium is excited to announce its third symposium will take place in San Francisco on September 20, 2018 at the St. Regis Hotel. Headlined by keynote speaker Tim Draper, founder of Draper Associates and the Draper Venture Network, additional speakers include crypto industry veterans as well as digital asset fund managers. The all-day conference will address legal and operational concerns germane to the digital asset industry, as well as emerging trends in operations and raising capital from institutional investors.
“We are excited to present a program that will focus on the institutionalization of the digital asset space, specifically: what is happening with custody of digital assets,” said conference co-chair Bart Mallon of the law firm Cole-Frieman & Mallon LLP. Lewis Chong of Harneys, another conference co-chair, echoed those sentiments noting that, “clients are keenly aware of the various ways that custody is emerging and evolving to meet investor desire for the safety of digital assets.”
Sam McIngvale, the product lead at Coinbase Custody and a conference panelist, said “custody has been a big issue for digital asset funds, we are excited to be part of the emerging solution set and to talk about the other trends we are seeing with this asset class.”
Registration is now open on the CoinAlts Fund Symposium website – current early bird pricing for investment managers is $300 per person and $950 per person for service providers. Early bird pricing ends on August 31, 2018, after which the price will be $500 and $1,200 respectively. The Symposium together with Coinbase is also hosting a networking event exclusively for women in the digital asset community: Women in Crypto which will be held on September 19, 2018 at Rooftop, Hotel VIA.
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About the CoinAlts Fund Symposium
The CoinAlts Fund Symposium was established by four firms with practices significantly devoted to fund managers in the cryptocurrency and digital asset space. Cohen & Company specializes in the investment industry and advises cryptocurrency funds on important tax, audit and operational matters. 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. Harneys is a leading international offshore law firm that acts for both issuers of digital assets and investment funds who invest in them. Members of our team are members of a number of the leading industry working groups in the BVI, Cayman Islands and the United States who are contributing to the thought leadership and industry insight in these areas.