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:

Annual Compliance & Other Items
Annual Fund Matters
Annual Management Company Matters
Regulatory & Other Items from 2018 Compliance Calendar

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.

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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.

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Annual Fund Matters

New Issue Status. On an annual basis, managers need to conﬁrm or reconﬁrm the eligibility of investors that participate in initial public oﬀerings or new issues, pursuant to 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.

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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.

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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:

On February 6, 2018, SEC Chairman Jay Clayton stated at a Senate hearing, “I believe every ICO I have seen is a security”.
On September 11, 2018, the SEC settled charges against an ICO platform for operating as an unregistered broker-dealer.
On October 11, 2018 the SEC issued an Investor Alert that warned against ICOs claiming SEC approval or impersonating the SEC. Also October 11th, the SEC obtained an emergency stop order against an ICO company for falsely claiming SEC approval. However, on November 27, 2018, a federal judge denied an SEC motion for a temporary restraining order against the ICO company, ruling that the SEC had not yet proven that the ICO was a security. Further, on October 22, the SEC obtained an order to suspended the trading of a cryptocurrency company for falsely claiming to be an SEC-qualified custodian.
On November 16, 2018, the SEC reached two settlements with companies for offering and selling unregistered securities through ICOs, and the companies have agreed to register the tokens from these past ICOs as securities with the SEC as part of the settlement agreements. Additionally, the SEC released a statement taking the position that the federal securities laws apply to ICOs, and that it is not too late for past ICO issuers to comply with these laws.
On November 29, 2018, the SEC settled two charges against celebrities for endorsing and promoting several ICOs. Both celebrities failed to disclose to investors that they had been paid to promote the ICOs. The terms of the settlements included disgorgement of profits and civil penalties of $300,000 and $100,000.

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:

CIMA-Registered Cayman Funds – registered funds must have appointed the new officers by September 30, 2018, but do not need to confirm the identity of the officers via CIMA’s Regulatory Enhanced Electronic Forms Submission (“REEFS”) portal until December 31, 2018. Managers should confirm that they have appointed individuals to the AML officer positions if they have not already done so.
Unregistered Cayman Fund – unregistered funds do not need to appoint the new officers until December 31, 2018, and they do not need to confirm the identity of these officers via the REEFS portal.

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.

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Compliance Calendar

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

Deadline	Filing
December 17, 2018	IARD Preliminary Renewal Statement payments due (submit early to ensure processing by deadline)
December 27, 2018	Last day to submit filings via IARD prior to year end
December 31, 2018	Review RAUM to determine 2019 investment adviser registration and Form PF filing requirements
December 31, 2018	Deadline for CIMA-registered funds formed prior to June 1, 2018 to confirm the identity of new AML officers via REEFS
January 15, 2019	Quarterly Form PF due for large liquidity fund advisers (if applicable)
January 31, 2019	“Annex IV” AIFMD filing
February 14, 2019	Registered CTAs must submit a 2018 year-end report
February 14, 2019	Quarterly Form 13F updates due
February 14, 2019	Annual Form 13H updates due
February 14, 2019	Annual Schedule 13G updates due
March 1, 2019	Deadline for re-certification of CFTC exemptions
March 1, 2019	Quarterly Form PF due for larger hedge fund advisers (if applicable)
March 1, 2019	Large-sized CPOs must submit a quarterly report (CPO-PQR)
March 31, 2019	Deadline to update and file Form ADV Parts 1, 2A & 2B
March 31, 2019	Small and mid-sized registered CPOs must submit a quarterly report (CPO-PQR) for the fourth quarter of 2018
Periodic	Fund managers should perform “Bad Actor” certifications annually
Periodic	Amendment due on or before anniversary date of prior Form D and blue sky filing(s), as applicable, or for material changes
Periodic	CPO/CTA Annual Questionnaires must be submitted annually, and promptly upon material information changes

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

Clients, Friends, Associates:

We hope that you had an enjoyable summer. The past quarter saw further interest in digital assets from regulators, as well as enforcement actions and indications of possible regulatory changes. In the traditional investment management space, this summer saw a continuation of the bull market. As we move into the fourth quarter, we would like to provide an overview of items we hope will help you stay up-to-date with regulatory developments.

In addition to the discussion below, we would like to announce a couple of firm-related items:

CoinAlts Fund Symposium. In September, preceded by a well-attended Women in Crypto networking event sponsored by Coinbase, founding sponsor Cole-Frieman & Mallon hosted its third successful full day Symposium in San Francisco. Speakers including keynote Tim Draper, founder of Draper Associates, DFJ and the Draper Venture Network and Joe Eagan of Polychain Capital explored issues key to fund managers and investors in the digital asset space.

CFM San Francisco. We are delighted to announe our overflowing San Francisco team will shortly relocate to expanded premises at 255 California Street.

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SEC Matters

SEC Chairman Hints at Changes in Investor Standards. On August 29, Securities and Exchange Commission (“SEC”) Chairman Jay Clayton spoke at the Nashville 36|86 Entrepreneurship Festival. He discussed issues the SEC is focused on or intends to focus on, including initial coin offerings (“ICOs”), promoting capital formation for public companies or companies considering going public, and rethinking the SEC’s current private offering exemption framework. Of note, Chairman Clayton stated that the SEC should explore how the current private offering exemption landscape could be simplified and streamlined. In particular, the Chairman noted that the SEC should examine the possibility of focusing on factors beyond investor wealth (i.e. accredited investor status), such as investor sophistication or investment amount.

SEC Releases Best Execution Deficiencies Alert. On July 11, the Office of Compliance Inspections and Examinations of the SEC released an alert outlining common deficiencies observed in examinations of advisers’ “best execution” obligations. These requirements come from the Investment Advisers Act of 1940, as amended, and impose a duty on advisers to execute trades so that total costs and proceeds are most favorable to clients. While best execution obligations depend on the facts of each situation, the SEC observed the following common deficiencies:

Not Performing Reviews – advisers were unable to provide evidence that they periodically and systematically reviewed the broker-dealers used to execute transactions.
Not Considering Materially Relevant Factors in Broker-Dealer Services – advisers did not consider the full range and quality of broker-dealers’ services.
Not Seeking Other Broker-Dealers – advisers often used only one broker-dealer for all of their clients without evaluating the services, quality, and costs of others.
Not Disclosing Best Execution Practices – advisers did not fully disclose best execution practices to their clients.
Not Disclosing Soft Dollar Arrangements – soft dollar arrangements (i.e. commissions in exchange for brokerage and research services) were not fully and fairly disclosed in advisers’ Form ADVs.
Not Properly Allocating Mixed Use Products and Services – advisers did not properly allocate the costs of mixed use products or services (i.e. products or services obtained using soft dollars, where that product or service is also used for non-investment purposes, such as accounting or marketing). Additionally, advisers did not properly document the reasons for mixed use product or service allocations.
Inadequate Policies and Procedures – advisers lacked policies, had insufficient internal controls, or did not have policies tailored to their investment strategy.
Not Following Policies and Procedures – advisers failed to follow their own best execution policies and procedures.

In light of the deficiencies listed above, advisers should review their best execution policies and procedures, and contact legal counsel or a compliance professional with any questions.

Hedge Fund Adviser Charged with Short-and-Distort Scheme. On September 12, the SEC charged a hedge fund advisor with illegally profiting from a “short-and-distort” scheme. The adviser is alleged to have released false information about a public pharmaceutical business after shorting the company. The adviser allegedly used reports, interviews, and social media to spread false claims that, for example, the pharmaceutical company was “teetering on the brink of bankruptcy”. The SEC is seeking a permanent restraining order, disgorgement of ill-gotten gains, and civil penalties.

SEC Charges Adviser for Risky Investments and Secret Commissions. On July 18, the SEC charged an adviser and its CEO with misleading investors by putting their capital in risky investments and secretly pocketing large commissions from such investments. The adviser and CEO are accused of misleading investors about the risks of the investments, overbilling, concealing financial conflicts, and violating the anti-fraud and registration provisions of federal securities laws. The SEC is seeking a permanent injunction, disgorgement of ill-gotten gains and losses avoided plus prejudgment interest, and civil monetary penalties.

CFTC/NFA Matters

CFTC Chairman Outlines Increased CFTC Enforcement. On October 2, the Commodities Futures Trading Commission (“CFTC”) Chairman Christopher Giancarlo summarized the CFTC’s increased enforcement efforts from the prior fiscal year in a speech to the Economic Club of Minnesota. These efforts include:

Enforcement Actions – in the prior fiscal year, the CFTC filed approximately 25% more enforcement actions than each of the prior three fiscal years.
Large-Scale Matters – the CFTC has increased enforcement actions against large-scale matters (i.e. matters that threaten basic market integrity). In the CFTC’s last fiscal year, it brought more than three times the average number of large-scale actions as the previous administration.
Manipulative Conduct – the CFTC has brought more than five times the previous average number of actions against manipulative conduct in the past fiscal year. Such conduct includes fraud, spoofing (i.e. bidding with the intent to cancel before execution), and the use of technology to manipulate order books.
Accountability – the CFTC has prioritized individual accountability, and approximately 70% of the past fiscal year’s cases involved charges against individuals who committed illegal acts.
Partnership with Criminal Enforcement – the CFTC has filed “far more actions in parallel” with criminal law enforcement partners than in any previous year.
Whistleblower Awards – with respect to whistleblowers, the CFTC has strengthened protections, granted a record number of awards, and received a record number of tips and complaints.

With these increased enforcement efforts in mind, managers of funds subject to CFTC jurisdiction should ensure they are up-to-date with CFTC filings and regulations.

CTA Associated Person and Introducing Broker Charged with Fraud. On August 10, the CFTC settled charges against an associated person of a commodity trading adviser (“CTA”) and introducing broker. The charges were based on a fraudulent trading scheme where the trader entered unauthorized commodities trades in customers’ accounts, transferred profitable trades to his own account, and left losses in the clients’ accounts. The settlement included a cease and desist order, a permanent ban from engaging in trading with any CFTC-registered entity, and a $100,000 civil monetary penalty.

Digital Asset Matters

Regulators continued to show interest and initiate enforcement actions in the digital asset space. Below is a summary of certain key digital asset items from the third quarter. For a complete review of these and other crypto developments, please consult our Third Quarter Digital Asset Regulatory Items blog post.

SEC Charges Digital Asset Hedge Fund Manager. On September 11, the SEC announced the settlement of charges against a digital asset hedge fund and its manager. The charges include misleading investors, offering and selling unregistered securities, and failing to register the hedge fund as an investment company. After being contacted by the SEC, the fund offered rescission and disclosed its previous misstatements to investors. The settlement included cease-and-desist orders, censure, 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 ICO platform. The business was charged with failing to register as a broker-dealer, as well as offering 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.

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. 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.

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 CTAs that are NFA members engaged in certain digital asset activities. The new disclosures cover, for example, the volatility and cybersecurity risks of digital assets. Additional details are available in our recent blog post.

Offshore Matters

Cayman Islands Delays AML Officer Deadline. Under new Cayman Islands requirements, investment funds that conduct business in or from the Cayman Islands must appoint individuals to new anti-money laundering officer positions. The Cayman Islands Monetary Authority (“CIMA”) has delayed certain deadlines for funds that launched prior to June 1, 2018:

CIMA-Registered Cayman Funds – registered funds still must have appointed the new officers by September 30, 2018, but now do not need to confirm the identity of the officers via CIMA’s Regulatory Enhanced Electronic Forms Submission (“REEFS”) portal until December 31, 2018.
Unregistered Cayman Funds – unregistered funds do not need to appoint the new officers until December 31, 2018, and they do not need to confirm the identity of these officers via the REEFS portal.

Funds formed on or after June 1, 2018 must have appointed the officers (and confirmed such officers through REEFS for registered funds) at launch. The new roles must be filled by individuals, and some service providers may be willing to provide individuals to serve such roles. We recommend fund managers discuss anti-money laundering compliance with offshore counsel and the fund’s administrator.

Other Matters

FINRA Warns of Regulator Impersonators. On July 13, FINRA issued a warning that persons claiming to be working for FINRA have been calling firms and attempting to obtain confidential information. In particular, FINRA warned that the use of overseas telephone numbers or email addresses indicates a likely scam, as well as emails from suspicious domains that do not end with “@finra.org” and that contain attachments or embedded links. If you have questions about the legitimacy of purported FINRA communications, contact your FINRA Coordinator.

New York Issues Sexual Harassment Compliance Mandate. Managers with operations in New York State and New York City should be aware of recent changes to employers’ obligations with respect to sexual harassment. Effective October 9, 2018, all employers in New York State are required to adopt a sexual harassment prevention policy equal to or greater than the standards of the state-issued model policy. Additionally, New York State employers must provide sexual harassment prevention training annually that is equal to or greater than the state-created model. This training must be completed by current employees by January 1, 2019, and by new hires within 30 days of being hired. Managers that may be subject to these new requirements can learn more on New York State’s Combating Sexual Harassment in the Workplace website. New York City has also implemented similar training requirements for employers with 15 or more employees, which will take effect on April 1, 2019. Additionally, effective September 6, 2018, New York City employers must post a sexual harassment poster and distribute a fact sheet to new employees.

SEC Charges Firm for Deficient Cybersecurity. On September 26, the SEC settled charges against a broker-dealer/investment adviser based on the firm’s deficient cybersecurity procedures after parties posing as contractors accessed customers’ personal information. The charges are a reminder of the importance of maintaining strong cybersecurity policies and procedures. Firms should be aware that cybersecurity is an on-going obligation and has become a focus of the SEC.

IRS Ends Voluntary Disclosure Program. On September 28, the Internal Revenue Service ended the 2014 Offshore Voluntary Disclosure Program (“OVDP”). U.S. taxpayers are required to report and pay taxes on certain offshore assets and face potential stiff criminal and civil penalties for failing to do so, and the OVDP was designed to offer taxpayers certain protections from these penalties. Fund managers with unreported foreign assets that were not able to meet the September 28, 2018 deadline should discuss their options with tax counsel.

New Law Expands Disclosure and Approval Requirements for Investments by Foreign Entities. On August 13, the Foreign Investment Risk Review Modernization Act (“FIRRMA”) was signed into law. It expands the scope of investments by non-U.S. investors in critical domestic tech companies that must be disclosed to and approved by the federal government in an effort to strengthen national security. An example investment within the scope of FIRRMA is an investment by a non-U.S. entity in a tech company that gives the investing entity access to material non-public technical information. While there are limits and exemptions to the scope of FIRRMA and the typical fund will not need to worry about its new requirements, venture funds with foreign limited partners or foreign co-investors should be mindful of the expanded approval requirements.

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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
October 10, 2018	Form 13H amendment due for large traders if the information contained in the filing became inaccurate in Q3
October 15, 2018	Quarterly Form PF due for Large Liquidity Fund Advisers (for funds with December 31 fiscal year-ends) filing for Q3 2018 (if applicable)
October 15, 2018	Extended deadline to file Reports of Foreign Bank and Financial Accounts (FBAR)
October 30, 2018	Registered investment advisers must collect access persons’ personal securities transactions
November 14, 2018	Form PR filings for registered CTAs that must file for Q3 within 45 days of the end of Q3 2018
November 14, 2018	Form 13F is due for certain institutional investment managers
November 30, 2018	Form PF filings for Large Hedge Fund Advisers with December 31 fiscal year-ends filing for Q3 2018
November 30, 2018	Large registered CPOs must submit a pool quarterly report (CPO-PQR)
December 17, 2018	Deadline for paying annual IARD charges and state renewal fees
December 31, 2018	Small and mid-sized registered CPOs must submit a pool quarterly report (CPO-PQR)
December 31, 2018	Deadline for CIMA-registered Cayman funds formed prior to June 1, 2018 to confirm the identity of appointed anti-money laundering officers via REEFS; deadline for unregistered Cayman funds to appoint anti-money laundering officers
December 31, 2018	Cayman funds regulated by CIMA that intend to de-register (i.e. wind down or continue as an exempted fund) should do so before this date in order to avoid 2019 CIMA fees
Periodic	Fund managers should perform “Bad Actor” certifications annually
Periodic	Amendment due on or before anniversary date of prior Form D and blue sky filing(s), as applicable, or for material changes
Periodic	CPO/CTA Annual Questionnaires must be submitted annually, and promptly upon material information changes

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

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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

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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.

NFA to Require Disclosure of Digital Asset Activities

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CPOs and CTAs to Augment Disclosure Documents

On July 20, 2018, the National Futures Association (“NFA”) submitted an Interpretive Notice titled Disclosure Requirements for NFA Members Engaging in Virtual Currency Activities to the Commodity Futures Trading Commission (“CFTC”). Through Section 17(j) of the Commodity Exchange Ac (“CEA”), the NFA has invoked the “ten-day” provision to allow the Interpretive Notice to become effective 10 days after its submission to the CFTC. The NFA has proposed this Interpretive Notice in an effort to better inform and notify consumers of the risks involved with trading and investing in cryptocurrencies. This Interpretive Notice sets forth disclosure requirements for two groups: (1) futures commission merchants (“FCMs”) and introducing brokers (“IBs”) and (2) commodity pool operators (“CPOs”) and commodity trading advisors (“CTAs”).

Proposed Interpretive Notice

The proposed Interpretive Notice specifies the following requirements:

For FCMs and IBs:

provide customers with the NFA Investor Advisory – Futures on Virtual Currencies Including Bitcoin and the CFTC Customer Advisory: Understand the Risk of Virtual Currency Trading (collectively, the “Advisories”) and for introduced accounts, the FCM or IB may provide the Advisories;
provide customers who traded a virtual currency derivative prior to the issuance of the Interpretive Notice with the Advisories within 30 calendar days of the Interpretive Notice’s effective date;
provide customers of FCMs and IBs offering services in spot market virtual currencies with a standardized disclosure^[1] that specifically states that the NFA does not have regulatory oversight authority over underlying or spot virtual currency products or transactions or virtual currency exchanges, custodians, or markets;
provide the Advisories to a customer at or before the time the customer engages in a virtual currency derivative transaction;
provide the standardized disclosure at or before the time a customer or counterparty engages in any underlying or spot virtual currency activity with or through the FCM or IB;
provide retail customers the Advisories and standardized disclosure language in writing or electronically in a prominent manner designed to ensure that the customer is aware of them; and
display the standardized disclosure language on any promotional materials related to spot market virtual currencies.

For CPOs and CTAs:

address the following areas that are applicable to their activities in their disclosure documents, offering documents, and promotional material related to virtual currencies: (1) unique features of virtual currencies; (2) price volatility; (3) valuation and liquidity; (4) cybersecurity; (5) the opaque spot market; (6) virtual currency exchanges, intermediaries, and custodians; (7) the regulatory landscape; (8) technology; and (9) transaction fees;
customize disclosure documents and offering documents to address all the unique risks related to their particular activities;
include a standardized disclosure[2] in disclosure documents, offering documents, and promotional materials related to virtual currencies addressing the limits of the NFA’s oversight and informing investors that there currently is no sound or acceptable practice that the NFA can use to verify the ownership and control of underlying or spot virtual currencies (this is a requirement of CPOs or CTAs that operate a pool, exempt pool, or trading program that trades spot market virtual currencies); and
provide a standardized disclosure[3] to customers and counterparties that specifically states that the NFA does not have regulatory oversight authority over underlying or spot virtual currency activities and display it in any promotional materials for any spot market virtual currency activities (other than as an investment in a pool or managed account program) engaged in by a CPO or CTA.

“Spot” Digital Assets vs. Digital Asset Derivatives

Throughout the proposed Interpretive Notice the NFA discusses both spot and derivative digital assets. “Spot” digital assets are digital assets that are purchased for cash intended for immediate delivery and not at some future date. The CFTC generally does not oversee spot digital assets, other than in instances of fraud or manipulation. In contrast, digital asset derivatives are instruments that stem from and are priced in comparison to the underlying digital asset, with the underlying asset intended to be delivered at a future date. Digital asset derivatives include instruments such as futures and options. Unlike spot digital assets, the CFTC and NFA have jurisdiction over the digital asset derivatives.

What comes next?

Over the last few days our law firm has spoken with both the NFA and CFTC about this matter. Although they could not provide more information regarding the drafting of the Interpretive Notice, they mentioned that once the Interpretive Notice becomes effective, individuals subject to the Interpretive Notice will be given time to become compliant. They also mentioned that it likely that the NFA will issue another announcement that will publicize the effective date of the notice and when qualifying members need to be in compliance.

Conclusion

It is unclear if the CFTC will take up the NFA’s Interpretive Notice for approval or if the Interpretive Notice will become effective 10 days after its submission to the CFTC. However, it should be noted that the majority of NFA proposals sent to the CFTC are approved. Despite this, all FCMs, IBs, CPOs, and CTAs should review the various indicated communications and documents to prepare for the potential approval of the Interpretive Notice. We will continue to report on this issue.

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Links to the other NFA items on digital assets:

[1] The standardized disclosure required is the following: [NAME OF NFA MEMBER] IS A MEMBER OF NFA AND IS SUBJECT TO NFA’S REGULATORY OVERSIGHT AND EXAMINATIONS. HOWEVER, YOU SHOULD BE AWARE THAT NFA DOES NOT HAVE REGULATORY OVERSIGHT AUTHORITY OVER UNDERLYING OR SPOT VIRTUAL CURRENCY PRODUCTS OR TRANSACTIONS OR VIRTUAL CURRENCY EXCHANGES, CUSTODIANS OR MARKETS.

[2] The standardized disclosure required is the following: [NAME OF NFA MEMBER] IS A MEMBER OF NFA AND IS SUBJECT TO NFA’S REGULATORY OVERSIGHT AND EXAMINATIONS. [NAME OF NFA MEMBER] HAS ENGAGED OR MAY ENGAGE IN UNDERLYING OR SPOT VIRTUAL CURRENCY TRANSACTIONS IN A [COMMODITY POOL OR MANAGED ACCOUNT PROGRAM]. ALTHOUGH NFA HAS JURISDICTION OVER [NAME OF NFA MEMBER] AND ITS [COMMODITY POOL OR MANAGED ACCOUNT PROGRAM], YOU SHOULD BE AWARE THAT NFA DOES NOT HAVE REGULATORY OVERSIGHT AUTHORITY FOR UNDERLYING OR SPOT MARKET VIRTUAL CURRENCY PRODUCTS OR TRANSACTIONS OR VIRTUAL CURRENCY EXCHANGES, CUSTODIANS OR MARKETS. YOU SHOULD ALSO BE AWARE THAT GIVEN CERTAIN MATERIAL CHARACTERISTICS OF THESE PRODUCTS, INCLUDING LACK OF A CENTRALIZED PRICING SOURCE AND THE OPAQUE NATURE OF THE VIRTUAL CURRENCY MARKET, THERE CURRENTLY IS NO SOUND OR ACCEPTABLE PRACTICE FOR NFA TO ADEQUATELY VERIFY THE OWNERSHIP AND CONTROL OF A VIRTUAL CURRENCY OR THE VALUATION ATTRIBUTED TO A VIRTUAL CURRENCY BY [NAME OF NFA MEMBER].

[3] The standardized disclosure required is the following: [NAME OF NFA MEMBER] IS A MEMBER OF NFA AND IS SUBJECT TO NFA’S REGULATORY OVERSIGHT AND EXAMINATIONS. HOWEVER, YOU SHOULD BE AWARE THAT NFA DOES NOT HAVE REGULATORY OVERSIGHT AUTHORITY OVER UNDERLYING OR SPOT VIRTUAL CURRENCY PRODUCTS OR TRANSACTIONS OR VIRTUAL CURRENCY EXCHANGES, CUSTODIANS OR MARKETS.

Cole-Frieman & Mallon 2018 Second 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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July 12, 2018

Clients, Friends, Associates:

We hope that you are enjoying the start of summer. Although the second quarter is typically not as busy as the first quarter from a regulatory or compliance perspective, we continue to see rapid developments in the digital asset space. As we move into the third quarter, we would like to provide a brief overview of some items we hope will help you stay abreast of these developments.

In addition to the discussion below, we would like to announce a couple of firm items:

CFM Atlanta. Our Atlanta office has just moved into new space in the heart of Buckhead. The new office address is 3348 Peachtree Road NE, Suite 1030, Atlanta, GA 30326.

CoinAlts Fund Symposium. In April founding sponsor Cole-Frieman & Mallon hosted its second full day Symposium attended by over 300 professionals, students, and investors in New York. Featuring twenty eight speakers, including key-notes, John Burbank of Passport Capital and Mark Yusko of Morgan Creek Capital Management, CoinAlts East presented a broad spectrum of content essential to managers and investors in the digital asset space. Our next CoinAlts Fund Symposium will take place in San Francisco on September 20, 2018. More details to follow.

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GDPR

GDPR Effective May 25. The General Data Protection Regulation (“GDPR”) went into effect on May 25, 2018 as part of the European Union’s effort to protect personal data. Any person or business that handles EU residents’ personal data must comply with the regulation. GDPR also applies to businesses established outside of the EU if their activities involve processing personal data related to offering goods or services to persons within the EU. US 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 with EU resident investors, but no presence within in the EU may also be required to appoint an EU local representative unless they can demonstrate processing is “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, but it may be challenging at present to find EU counsel that will advise on this requirement in the absence of more guidance from EU regulators. For more information on GDPR, including compliance items for hedge fund managers, please see our earlier post.

Legal and Regulatory Developments

SEC Proposes Rules Regarding Form CRS, Form ADV, and Disclosures in Retail Communications. On April 18, 2018, the Securities and Exchange Commission (“SEC”) proposed new rules and amendments to certain rules and forms under the Investment Advisers Act of 1940, as amended (“Advisers Act”) and the Securities Exchange Act of 1934, as amended. One proposal would require both registered investment advisers and broker-dealers to provide a summary (“Form CRS”) disclosing the nature and details of their relationship to retail investors. Form CRS would be added as a section to Form ADV and would disclose: (i) the relationships and services the firms offer; (ii) the standard of conduct and fees and costs associated with the services; (iii) specified conflicts of interest; and (iv) reportable legal or disciplinary events on the firm’s part or its financial professionals.

The SEC also proposed two new rules to reduce investor confusion caused by communications with broker-dealers and investment advisers by placing additional requirements on retail investor communications. One rule would restrict broker-dealers’ use of the terms “adviser” and “advisor” when communicating with retail investors. The other rule would require broker-dealers and investment advisers to disclose their SEC registration status in retail investor communications. It would also require associated natural persons and supervised persons to disclose their relationships with broker-dealers or investment advisers in retail investor communications. Comments to the SEC are due on or before August 7, 2018.

SEC Proposes Interpretation of Standard of Conduct for Investment Advisers. On April 18, 2018, the SEC proposed an interpretation of the conduct standard for investment advisers under the Advisers Act and requested comment on its proposal. The SEC also seeks comment on the following proposed requirements for SEC registered investment advisers (“RIAs”): (i) federal licensing and continuing education; (ii) periodic account statements; and (iii) financial responsibility requirements similar to those required of broker-dealers. Comments to the SEC are due on or before August 7, 2018.

SEC Charges 13 Private Fund Advisers for Repeated Form PF Filing Failures. On June 1, 2018, the SEC announced settlements with 13 SEC RIAs for repeatedly failing to provide risk monitoring information. The SEC found that the advisers continually failed to file annual reports on Form PF. Section 204(b) of the Advisers Act requires large fund managers to report information such as assets under management, fund strategy, and fund performance on Form PF. The SEC uses these reports to inform their rulemaking process and to target examinations and enforcement investigations. The SEC found that each of the advisers violated the Form PF reporting requirements under the Advisers Act. Although the advisers did not admit or deny the SEC’s findings, they agreed to be censured, cease and desist, and to each pay a $75,000 civil penalty.

SEC Charges Hedge Fund Adviser with Deceiving Investors. On May 9, 2018, the SEC charged a hedge fund adviser and certain principals, including the CEO and a former portfolio manager, for fraudulently overvaluing its funds by hundreds of millions of dollars. Defendants are alleged to have placed trades in exchange for inflated broker-dealer quotes and applied “imputed” mid-point valuations in a manner that further inflated the value of securities. The SEC is seeking permanent injunctions, the return of illicit profits with interest, and civil penalties.

SEC Charges Hedge Fund Firm for Asset Mismarking and Insider Trading. The SEC announced on May 8, 2018 that a manager agreed to settle charges regarding insider trading and fraudulent overvaluation of certain assets held by its hedge funds. The SEC found that two of the portfolio managers overstated the values of their hedge funds’ securities. In a separate order, the SEC alleged that the CFO failed to supervise the two portfolio managers appropriately and respond to red flags regarding the mismarking. The SEC also found that the portfolio managers violated insider trading laws by trading pharmaceutical securities on confidential information obtained through a former U.S. Food and Drug Administration official.

Second Circuit Amends Martoma Decision. On June 25, 2018, the U.S. Court of Appeals for the Second Circuit amended its decision in United States v. Martoma to clarify tippee liability in insider trading cases. As we discussed in a previous Quarterly Update, the Second Circuit once again upheld a former portfolio manager’s 2014 conviction for insider trading. In its amended decision, the court confirmed that a “meaningfully close personal relationship” is not required for tippee liability in insider trading cases.

Digital Asset Matters

We see many thought-provoking items in the digital asset sector as the industry moves towards greater institutional infrastructure. After numerous public statements by SEC officials, token issuers understand that there are several compliant ways to raise capital through token offerings. One way is through Regulation A+, which has many advantages over other securities offering mechanisms. We are also seeing many groups use airdrops as a way to try to circumvent the private placement regulatory regime. One item to specifically note, is that privately placed tokens may have resale restrictions that could create issues for both the token issuers and token purchasers. We are also aware of several groups beginning the process of registering as alternative trading systems or otherwise becoming broker-dealers and/or qualified custodians.

Outside of these items, we have summarized some notable regulatory developments in the second quarter. For a complete review of these developments, please consult our Digital Asset Regulatory Items blog post.

CFTC Issues Advisory on Virtual Currency Derivatives. On May 21, 2018, the Commodity Futures Trading Commission (“CFTC”) Division of Market Oversight and the Division of Clearing and Risk issued an advisory regarding virtual currency derivative products. The CFTC outlined key expectations for exchanges and clearinghouses operating in the virtual currency derivatives space:

Enhanced Market Surveillance – an adequate market surveillance program would include sharing information on the underlying spot markets, allowing the CFTC to access a broad range of exchange trade data (i.e., trader identity, volumes, times, prices, and quotes), and real-time monitoring of all trading activity to identify red flags.
Close Coordination with the CFTC Surveillance Group – exchanges should engage in regular discussions with the CFTC on surveillance of virtual currency derivatives contracts and allow access to data on settlement processes referenced in such contracts.
Large Trader Reporting – exchanges should set large trader reporting thresholds for any contract at five BTC (or equivalent) to increase their ability to focus on relevant market information.
Outreach to Members and Market Participants – exchanges should obtain comments from stakeholders on listing issues beyond contract terms and conditions. Comments should include explanations of opposing views and the exchanges’ perspectives.
Derivative Clearing Organization’s Risk Management – the CFTC requests information from derivative clearing organizations (“DCOs”) necessary to assess the suitability of proposed initial margin requirements. The CFTC may require DCOs to amend inadequate initial margins. They may also request information regarding the approval process of proposed contracts.

NASAA Combats ICO Fraud. On May 21, 2018, the North American Securities Administrators Association (“NASAA”) announced its involvement in “Operation Cryptosweep,” one of the largest coordinated enforcement efforts against fraudulent Initial Coin Offerings (“ICOs”), crypto-related products, and cryptocriminals. Operation Cryptosweep is a combined effort between NASAA’s members, spanning more than 40 jurisdictions in the United States and Canada. Since April 2018, the operation has produced almost 70 inquiries and investigations in addition to 35 pending or completed enforcement actions related to digital assets and ICOs, including multiple actions against private funds. According to NASAA President Joseph Borg, these recent actions are only the beginning of further enforcement against ICO fraud.

Other Items

5th Circuit Issues Mandate on Fiduciary Rule. On June 21, 2018, the U.S. Court of Appeals for the Fifth Circuit issued a mandate regarding the Department of Labor’s (“DOL’s”) Fiduciary Rule (“Fiduciary Rule”) after months of uncertainty. The Fifth Circuit’s mandate effectuates its March 15 decision to vacate the Fiduciary Rule. Although the DOL’s Fiduciary Rule appears defeated, the court’s decision may prompt the SEC and other regulators to revisit their plans for fiduciary reform.

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 of 1940, as amended, by increasing the number of investors allowed in a qualifying venture capital fund from 100 to 250 investors. The Growth Act — which will take effect in late 2019 — defines a qualifying venture capital fund as one with less than $10 million “in aggregate capital contributions and uncalled committed capital.”

The CFTC and NASAA Sign Information Sharing Memorandum. The CFTC and NASAA signed a Memorandum of Understanding (“MOU”) regarding the sharing of non-public information on May 21, 2018. The MOU aims to forge a closer working relationship between the CFTC and individual state securities agencies— represented by the NASAA— to better enforce the U.S. Commodity Exchange Act of 1936, as amended (“CEA”) by promoting voluntary, inter-agency sharing of non-public information. NASAA President Joseph Borg believes the MOU could assist NASAA members in enforcing both securities and commodities law violations, particularly against schemes related to digital assets and other modern commodities.

NFA Develops Swaps Proficiency Program and Exam. The National Futures Association (“NFA”) announced on June 5, 2018 that its board approved the creation of an online proficiency requirements program and exam for all associated persons participating in swaps activities. The swaps proficiency program is part of the NFA’s mandate under the CEA, which requires the NFA to set training standards and proficiency testing for individuals and activities governed thereunder. The online program and exam are expected to launch in early 2020.

Cayman Islands Revises and Clarifies AML Regulations. As mentioned in previous updates, the Cayman Islands released the 2018 revisions to its Anti-Money Laundering (“AML”) regulations earlier this year. The following are some notable changes:

Non-Cayman Islands Monetary Authority (“CIMA”) registered funds (i.e., 4(4) funds) will be subject to AML regulations;
All investment funds (registered and unregistered) must designate natural persons to act as Anti-Money Laundering Compliance Officers (“AMLCOs”), Money Laundering Reporting Officers (“MLROs”), and Deputy Money Laundering Reporting Officers (“DMLROs”) by September 30, 2018 or, for funds registering after June 1, 2018, upon submission of the registration application; and
All investment funds (registered and unregistered) will be subject to enhanced AML processes and procedures.

CIMA also released a notice on April 6, 2018 to clarify its guidance notes on the AML regulations.

The guidance clarified that a fund could designate the same individual to serve as its AMLCO and MLRO. Also, if an MLRO, DMLRO, and AMLCO have been appointed, a person carrying out the relevant financial business of a fund may delegate to another the performance of functions outlined in the AML regulations. Significantly, managers should also note that these officers may be exposed to criminal sanctions for breach of their obligations. Failure to comply with CIMA’s AML regulations could result in an unlimited fine and imprisonment for two years. We recommend that fund managers discuss AML compliance and implementation issues with offshore counsel and the fund’s administrator.

Cayman Islands Appeals Court Holds That a Liquidator May Not Adjust a Shareholder’s NAV. The Cayman Islands Court of Appeal held that an official liquidator of a fund could not change a contractually agreed upon net asset value (“NAV”), even if it were based upon fraudulent numbers. The judge agreed with the lower court that allowing adjustment of the NAV would “interfere with the shareholders’ proprietary rights,” an action that legislators did not intend to permit. This outcome may benefit shareholders by providing certainty regarding a fund’s NAV and the benefits derived from “their rights under a valid and subsisting contract.”

Cayman Issues AEOI Portal Update. On May 29, 2018, the Cayman Islands issued an update regarding the Automatic Exchange of Financial Account Information Portal (“AEOI”). The statutory deadline for filing Common Reporting Standard (“CRS”) and US Foreign Account Tax Compliance Act, as amended, (“FATCA”) reporting was May 31, 2018. However, the Cayman Islands Department for International Tax Cooperation will allow Cayman Financial Institutions until July 31, 2018 to fulfill their 2017 CRS and US FATCA reporting obligations without facing adverse consequences, compliance measures, or penalties.

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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

June 29, 2018 – Delivery of audited financial statements to investors (private fund managers to fund of funds, including SEC, state, and CFTC registrants)
June 30, 2018 – Deadline for Cayman Island registered funds with a fiscal year end of December 31 to file the Fund Annual Return and audited financial statements with CIMA
June 30, 2018 – Deadline for making available AIFMD annual report for funds in or advertising in the EU (Alternative Investment Funds with a financial year ending on December 31st)
June 30, 2018 – Review transactions and assess whether Form 13H needs to be amended
July 15, 2018 – Quarterly Form PF due for large liquidity fund advisers
July 30, 2018 – Quarterly account statements due (CPOs claiming the 4.7 exemption)
July 30, 2018 – Collect quarterly reports from access persons for their personal
securities transactions
July 31, 2018 – Cayman Islands CRS and US FATCA reporting deadline without adverse consequences (for those who missed the initial May 31, 2018 deadline)
August 14, 2018 – Form 13F filing (advisers managing $100 million in 13F Securities)
August 14, 2018 – CTA-PR filing with NFA
August 29, 2018 – Quarterly Form PF due for large hedge fund advisers
August 29, 2018 – CPO-PQR filing with NFA
September 30, 2018 – Review transactions and assess whether Form 13H needs to amended
September 30, 2018 – Deadline to designate an MLRO, DMLRO, and AMLCO for Cayman Islands AML compliance
October 15, 2018 – Quarterly Form PF due for large liquidity fund advisers
October 15, 2018 – Annual Foreign Bank and Financial Accounts Report deadline (for those who missed the April 17 deadline)
Periodic – Fund managers should perform “Bad Actor” certifications annually
Periodic – Amendment due on or before anniversary date of prior Form D filing(s), or for material changes
Periodic – CPO/CTA Annual Questionnaires must be submitted annually, and promptly upon material information changes
Periodic – Form D and blue sky filings should be current

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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 – Second Quarter 2018

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The second quarter offers notable regulatory updates in the digital asset space. For your convenience, we provide an overview of these items down below.

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SEC MATTERS

Speeches & Testimony

Chairman Testifies on Cryptocurrencies Before the House Committee on Appropriations

On April 26, 2018, Securities and Exchange Commission (“SEC”) Chairman Jay Clayton testified before the Financial Services and General Government Subcommittee of the House Appropriations Committee that digital assets are divided into 2 categories: (1) a “pure medium of exchange”—considered to be “not a security”; (2) tokens—a tool “to finance projects.” Given the uncertainty around cryptocurrencies, this may suggest that even the SEC might not readily view all tokens as securities yet.

SEC Director Hinman Testifies Before the House That Many ICOs are Securities Offerings, Certain Utility Tokens Do Not Have Hallmarks of a Security

On April 26, 2018, SEC Director William Hinman stated his position that it is “hard to have an initial sale without a securities offering.” Consequently, Hinman believes that initial coin offerings (“ICOs”) will likely require registering as a securities offering or operating under an exemption. He clarified that it is possible for a token not to have the hallmarks of a security if the token was purchased solely for its functional use and not as an investment. For many issuers, it could mean that they can offer tokens for sale by relying on appropriate exemptions without having to comply with the SEC securities registration.

SEC Director Hinman Speaks at the Yahoo Finance All Markets Summit on Crypto

On June 14, 2018, SEC Director of the Division of Corporation Finance William Hinman spoke at the Yahoo Finance All Markets Summit on Crypto in San Francisco. He addressed questions regarding ICOs and token sales and whether a digital asset can be something other than a security. He mentioned that currently, neither Bitcoin nor Ether meet the Howey test. However, he cautioned that classification of whether an instrument is a security is not static and the classification can change as the instrument changes.

Releases

SEC Creates Senior Advisor for Digital Assets and Innovation Position

On June 4, 2018, the SEC announced that Valerie A. Szczepanik would be the agency’s first ever Senior Advisor for Digital Assets and Innovation. This newly created position will allow the SEC to explore how U.S. securities laws would apply to digital asset technologies such as ICOs and cryptocurrencies. Ms. Szczepanik has been with the SEC since 1997. During her tenure, she has been an Assistant Director for the Division of Enforcement’s Cyber Unit. Currently, Szczepanik serves as the Head of the SEC’s Distributed Ledger Technology Working Group, Co-Head of the Dark Web Working Group, and a member of the FinTech Working Group.

Enforcement

SEC Takes Civil Actions Against Fraudulent ICO

On April 2, 2018, the SEC filed a complaint in the United States District Court for the Southern District of New York against Centra Tech., Inc. (“Centra”) for raising at least $32 million in unregistered securities through a fraudulent ICO. Centra falsely claimed that it had partnered with VISA, Mastercard, and Bancorp to create a “crypto debit card.” The complaint seeks a permanent injunction to stop Centra’s activities and to return the ill-gotten gains to investors. The U.S. Attorney’s Office has also filed criminal charges against the two founders.

SEC Files Charges Against Titanium Blockchain

On May 22, 2018, the SEC filed charges in the United States District Court for the Central District of California against Titanium Blockchain for violating antifraud and registration provisions under federal securities laws. The company used false corporate relationships and testimonies to inflate the values of their digital assets. Under the guise of an ICO, they fraudulently raised up to $21 million in cash and digital assets.

Other

SEC Creates Mock Initial Coin Offering

The SEC has created howeycoins.com. The website is designed to educate the public about fraudulent ICOs and how to avoid being a victim.

CFTC MATTERS

Advisory

The CFTC Issues Advisory on Virtual Currency Derivatives

On May 21, 2018, the Commodity Futures Trading Commission (“CFTC”) issued key expectations for exchanges and clearinghouses regarding virtual currency derivative products. These include: i) enhanced market surveillance; ii) close coordination with the CFTC surveillance group; iii) large trader reporting; iv) outreach to members and market participants; and v) derivative clearing organization’s risk management. For more details on these key points, please refer to our second quarterly update.

Speeches

CFTC Gives Keynote at the FIA 40th Annual Law & Compliance Division Conference on the Regulation of Futures, Derivative, and OTC Products, Washington, D.C.

CFTC Commissioner Rostin Behnam. On May 3, 2018, CFTC Commissioner Rostin Behnam spoke at the Futures Industry Association’s 40th Annual Law & Compliance Division Conference on the Regulation of Futures, Derivative, and OTC Products. In his speech, the Commissioner noted that institutions look at digital assets as something more than a currency. He also acknowledged the National Futures Association’s work on understanding and regulating virtual currencies and their derivatives.

Commissioner Quintenz Announces the Establishment of TAC Subcommittees

CFTC Commissioner Brian Quintenz. On June 4, 2018, CFTC Commissioner Brian Quintenz announced the creation of the Technology Advisory Committee’s (“TAC”) four new subcommittees. The subcommittees will be tasked with exploring automated and modern trading markets, cybersecurity, distributed ledger technology and market infrastructure, and virtual currencies.

Enforcement

CFTC Files Complaint Regarding Fraudulent ATM Coin

On April 16, 2018, the CFTC filed a complaint against three investment funds for their connection with a “binary options” scheme that defrauded at least 6 U.S. clients of about $618,810. The managers invited investors to transfer their fund balances to a virtual currency firm in return for the fraudulent virtual currency called “ATM Coin.” Neither the defendants nor the executed transactions were registered with the CFTC or a registered exchange. One of the fund managers also faces criminal charges for altering records and obstructing the FBI investigation.

NFA MATTERS

Notice to Members

NFA Encourages FCMs and IBs to Review OFAC FAQs for Compliance Obligations

On May 3, 2018, the National Futures Association (“NFA”) released a notice recommending that futures commission merchants (“FCMs”) and introducing brokers (“IBs”) review the U.S. Treasury Department’s Office of Foreign Assets Control (“OFAC”) FAQs about compliance and sanctions with regard to illicit digital currency activities. The FAQs detail OFAC’s goal to combat terrorism and criminal exploitation of digital transactions, as well as compliance obligations in dealing with blocked persons or property.

FINRA MATTERS

Enforcement

FINRA Suspends a Member for Failure to Disclose Outside Business Activity.

On April 18, 2018, FINRA issued a $20,000 fine and a two-year suspension to a broker for failure to disclose his private blockchain business activity with his firm. According to FINRA, all firms’ employees must report outside business activities and any material changes to their firms. This rule is intended to strengthen investor protections against outside activities.

STATE MATTERS

California Legislation

The following bills regarding the digital asset space are moving through the California legislature.

CA AB-2658: it would define blockchain technology in California and create a government working group to evaluate the use of blockchain technology by CA businesses and the state government. The bill passed the State Assembly on May 30, 2018 and is currently in the State Senate.
CA SB-838: it would allow certain privately-owned corporations to amend their articles of incorporation to include provisions for the use of blockchain technology in recording information related to stock transactions. The bill passed the State Senate on May 17, 2018 and is currently in the State Assembly.

Colorado Division of Securities Participates in Coordinated International Crypto Crackdown

On May 3, 2018, the Colorado Securities Commission announced that it signed orders requiring Linda Healthcare Corporation and Broad Investments, LLC to cease and desist from selling securities in the state. The companies violated Colorado securities laws by promoting ICOs to Colorado residents without disclosing the risks involved.

Florida Chief Financial Officer Announces New Cryptocurrency Oversight Position

Jimmy Patronis, Florida Chief Financial Officer, released a statement on June 26, 2018 that Florida would be creating an oversight position for its cryptocurrency industry. In coordination with the Office of Financial Regulation and the Office of Insurance Regulation, this new oversight position aims to develop policy, legislation, and regulation regarding cryptocurrency.

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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

Regulation A+ for Token Offerings

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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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[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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