Tag Archives: cryptocurrency hedge fund

Crypto Headlines from Week of April 26 – Bitfinex/Tether & SeedInvest

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There were two big announcements in the crypto space this week and we anticipate that both will shape the dialogue in crypto circles over the course of the next few months.

NY AG Order re Bitfinex and Tether – the New York Attorney General announced an order requiring Bitfinex to provide certain information on its corporate activities to New York in connection with an investigation into Tether.  The central issue is whether Bitfinex used Tether funds to “hide the apparent loss of $850 million dollars of [Bitfinex] co-mingled client and corporate funds.”  The order was announced yesterday and sent the entire crypto market down 10%.  Bitfinex has released a statement in response to the order saying that Bitfinex and Tether are “financially strong – full stop.”  We anticipate this will be a major story over the next couple of weeks.

SeedInvest Receives ATS License – ever since the SEC released the DAO report in July 2017, firms have been trying to secure a broker-dealer with an Alternative Trading System.  A broker-dealer with an ATS designation would allow a digital asset trading platform to legally provide an exchange/trading service in the US.  SeedInvest (which was recently bought by Circle), through its affiliated broker-dealer SI Securities, just received the ATS designation (see here on page 11 – “The Firm operates an alternative trading system to facilitate the trading of securities previously purchased in private placement transactions through SI Securities.”).  The ATS designation in this instance allows the firm to have a trading system/platform for previously issues equity securities (private placements) and not for tokens; however, it is generally viewed that this is the first step toward FINRA ultimately allowing for the ATS designation to apply to a token platform.  We will see how this plays out with other platforms in the near future but this is certainly a sign that regulators are moving in the right direction.

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For more information on this topic, please see our collection of cryptocurrency fund legal and operational posts.

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

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

Notes on Regulation A+

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

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

Regulatory Obligations

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

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

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

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

Why Regulation A+?

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

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

Application for Initial Coin Offerings

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

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

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

Conclusion

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

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

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

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

Simple Agreement for Future Tokens (SAFT)

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SAFT Background for Cryptocurrency Funds

As we discussed in a recent post, the SEC Report on the DAO, issued in July of this year, discussed how the SEC views Initial Coin Offerings (ICOs). One key takeaway from this report was that some digital assets/ tokens fall within the definition of securities, depending on the facts and circumstances related to the nature of the particular digital asset/token. If an ICO is considered an offer and sale of a security, then that offering must comply with federal securities laws.  This means the token must either be registered as a security with the SEC or that the token qualifys for an exemption from registration requirements.

In an attempt to comply with SEC regulations and account for some of the uncertainties around regulation of these digital assets, some recent ICOs have launched using a Simple Agreement for Future Tokens (SAFT) along with an accompanying offering memorandum. The SAFT, modeled after Y Combinator’s Simple Agreement for Future Equity (SAFE), is an agreement offering future tokens to accredited investors. Instead of offering an immediately available token, these SAFTs offer the right to a token upon a triggering event. SAFTS are intended to be private offerings exempt from registration with the SEC. Notably, Protocol Labs, Inc. offered the right to purchase Filecoin tokens through a SAFT earlier this year. Since then, multiple other ICOs have launched using SAFTS, including Unikrn, StreamCoin Labs, and Kik Interactive.

Overview of SAFT documentation

As part of some ICO launches, investors are subscribing through a SAFT and accompanying offering memorandum.  The SAFT is an agreement signed by both the issuer and the purchaser of the future tokens. The general SAFT template includes various provisions which we outline below.

  • Country legends – disclaimers directed toward specific countries, including statements on registration and restrictions on transfer of the tokens.
  • Sale information – purchase amount and price, token amounts, and vesting period.
  • Background information – various events including network launch, dissolution events, and termination events are discussed. A network launch will generally trigger an issuance of tokens based on the purchase amount of each investor.
  • Purchaser and Issuer representations – various representations made by both the issuer and purchaser are included. Notably, the purchaser will represent that it has been advised that the SAFT is a security and has not been registered, and cannot be resold without the consent of the issuer. The agreement also includes the procedures for purchase of rights under the SAFT including the form of payment.
  • Miscellaneous/ transfer provisions – various miscellaneous provisions including transfer restrictions and rights under the SAFT.

SAFT Offering Memorandum

The offering memorandum is similar private placement memorandum (PPM) for a traditional hedge fund and provides the prospective investor with information on the structural and business aspects of the offering. Below is a non-exhaustive list of some of the major sections of the offering memorandum:

  • Legends and securities laws notices
  • Table of contents
  • Company overview
  • Description of the directors and management
  • Terms of the purchase rights and the SAFTS
  • Risk factors
  • Description of the use of proceeds
  • Description of the plan of distribution

Potential Issues

There are a number of potential issues, including legal and regulatory, that may arise through the use of SAFTS.

Is a SAFT a security?

The SEC has applied the Howey test to digital assets, concluding that a token may be a security based on specific facts and circumstances. To determine whether tokens are securities, the SEC has looked to whether there is an investment of money in a common enterprise with a reasonable expectation of profits to be derived from the entrepreneurial or managerial efforts of others.

The drafters of SAFTs have generally taken the position that SAFTs are securities (e.g., investment contracts). The SEC has commented in the past on SAFEs with respect to crowdfunding, mentioning that SAFEs are a type of security, warning investors to be cautious. SAFTs that are limited to accredited investors will likely elicit less concern from the SEC as they are not aimed at retail investors. It remains to be seen, however, whether the SEC will also consider SAFTs securities in a similar context with SAFEs. While any determination on whether the SAFT is a security will likely be based on the specific use of the underlying tokens, it seems likely that many SAFTs would be deemed securities because the purchasers are investing money (or other digital assets) in the rights to the future underlying token with the expectation of profits from the efforts of the issuers of the SAFT.

Restrictions on transfer

Under a SAFT, there is typically a restriction on the purchaser’s ability to transfer or make use of the tokens until the tokens are vested. Vesting takes place once the network is launched and the tokens are mined. A purchaser generally can, however, transfer its rights in a SAFT to another person or entity with the consent of the company issuing the SAFT. Below is a non-exhaustive list of some of the major provisions that should be in the transfer agreement.

  • Transfer of the SAFT
  • Consideration
  • Consent of the company that issued the SAFT
  • Transferor representations and warranties that it owns the SAFT and is able to transfer
  • Transferee representations that it will be bound by the terms of the SAFT

Source of funds

Many of these SAFTs allow purchasers to use various forms of consideration for these contracts including US dollars, Bitcoin, and other digital assets. This may raise anti-money laundering concerns around the source of the funds used for these purchases.

How do regulators view SAFTs?

US regulators have not provided specific guidance on the use of SAFTS. As discussed previously, the SEC has stated that some tokens are securities. Additionally, earlier this year, the SEC charged a businessman with allegedly running two fraudulent ICOs and appears to be taking an increasing interest in these issues. The SEC has mentioned the crowdfunding regulations in the SEC Report on the DAO, and the SEC seemed to be highlighting an option for certain fund sponsors. Given also that the SEC has commented on SAFEs with respect to venture and crowdfunding, it is possible that regulators will draw certain parallels between SAFEs and SAFTs in its views on these instruments. Unfortunately, until regulators issue additional guidance, it is not yet clear whether the SAFT in some cases will be sufficient to satisfy the SEC or other regulators.

Looking Forward

The SAFT represents some investment managers’ response to the concerns of the SEC and may encourage more ICOs to be based in the US. We hope the SEC and other regulators comment on their view of SAFTs, although much of the discussion over whether a SAFT or token is a security will remain a facts and circumstances determination.

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

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

SEC Issues Cryptocurrency/Digital Asset/ICO Report

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By: Bart Mallon (Co-Managing Partner of Cole-Frieman & Mallon LLP)

Certain Digital Assets are Securities Based on “Facts and Circumstances”

As has been widely anticipated by the cryptocurrency community, the SEC has finally made an initial declaration of the agency’s view that certain digital assets are securities subject to jurisdiction and regulation by the SEC.  In a series of four items (press release, investigative report, statement and investor bulletin), the SEC comes out with a strong warning to sponsors of Initial Coin Offerings (ICOs) to be careful of the U.S. securities laws.  While many will undoubtedly think the SEC missed a great opportunity to provide robust guidance (and leniency) to the industry, most market participants recognize that this series of discussions was the most likely outcome for many of these instruments (i.e. it is clear that they are securities).  Although it is not perhaps what the industry wanted, we at least have *something* to now go by and the industry can begin to figure out how it will structure itself from here.

Below we provide an overview of the various parts of the release as well as some of our observations.

SEC Four Items

The SEC released the following four items today which we describe in greater depth below:

  1. Press Release 2017-131
  2. Release No. 81207 (report)
  3. Divisions of Corporation Finance and Enforcement Statement (July 25, 2017)
  4. Investor Bulletin: Initial Coin Offerings

Press Release – the release discusses the investigative report it published on The DAO and discusses the investor bulletin created regarding ICOs.  The SEC cautions market participants to make sure they examine their activity with respect to ICOs and other structures built on blockchain and distributed ledger technology.  Most importantly the release states:

In light of the facts and circumstances, the agency has decided not to bring charges in this instance, or make findings of violations in the Report, but rather to caution the industry and market participants:  the federal securities laws apply to those who offer and sell securities in the United States, regardless whether the issuing entity is a traditional company or a decentralized autonomous organization, regardless whether those securities are purchased using U.S. dollars or virtual currencies, and regardless whether they are distributed in certificated form or through distributed ledger technology

SEC Report on the DAO – the report describes the rise and fall of The DAO, discusses how the related facts would be analyzed under the existing securities laws (Howey test), determines that DAO Tokens are securities, and makes the determination that certain “Platforms” are securities exchanges that should be (and should have been) registered with the SEC as securities exchanges.  The report ends by listing a number of SEC enforcement actions involving virtual currencies.  The SEC also provides the following warning to the industry:

Whether or not a particular transaction involves the offer and sale of a security—regardless of the terminology used—will depend on the facts and circumstances, including the economic realities of the transaction. Those who offer and sell securities in the United States must comply with the federal securities laws, including the requirement to register with the Commission or to qualify for an exemption from the registration requirements of the federal securities laws…These requirements apply to those who offer and sell securities in the United States, regardless whether the issuing entity is a traditional company or a decentralized autonomous organization, regardless whether those securities are purchased using U.S. dollars or virtual currencies, and regardless whether they are distributed in certificated form or through distributed ledger technology. In addition, any entity or person engaging in the activities of an exchange, such as bringing together the orders for securities of multiple buyers and sellers using established nondiscretionary methods under which such orders interact with each other and buyers and sellers entering such orders agree upon the terms of the trade, must register as a national securities exchange or operate pursuant to an exemption from such registration.

CorpFin/Enforcement Statement – the statement basically provides an overview of the U.S. securities regulatory framework and describes how the framework of laws and regulations are designed to protect investors.  It discusses the importance of “facts and circumstances” analysis, states that DAO Tokens are securities based on “facts and circumstances” and implores cryptocurrency market participants  to seek counsel from private attorneys or the SEC.  The statement also warns of bad actors and red flags.

Investor Bulletin – provides background on ICOs, discussed various concepts applicable to the digital asset industry (blockchain, virtual currency, virtual currency exchanges, smart contracts), and discusses the crowdfunding regulations.  The bulletin also alerts investors to the issues with getting money back in the event of a scam (tracing issues, international scope of digital assets, the fact there is no central regulator and there is no ability for the SEC to freeze digital assets) and describes the normal things to be careful of that are common in many scams.

Observations

The following are some quotes from the various items produced by the SEC which we found interesting, and our thoughts on those quotes.

Press Release

“Those participating in unregistered offerings also may be liable for violations of the securities laws.”

HFLB: we note that the SEC is intentionally being vague when it references “those participating” – this indicates they will be looking at all parties related to a particular transaction, from sponsors to exchanges to other persons within the ICO distribution chain.  

“Additionally, securities exchanges providing for trading in these securities must register unless they are exempt.”

HFLB: here they are basically saying any exchange that DAO Tokens were available on were acting as securities exchanges and needed to be appropriately registered as such.

“The DAO has been described as a “crowdfunding contract” but it would not have met the requirements of the Regulation Crowdfunding exemption because, among other things, it was not a broker-dealer or a funding portal registered with the SEC and the Financial Industry Regulatory Authority.”

HFLB: we find it interesting that the SEC is specifically talking about the crowdfunding regulations.  We think that many ICOs / token sales would be good candidates for these platforms (and some tokens have started in that way) and the SEC seems to be highlighting an option for certain fund sponsors.  Crowdfunding platforms are regulated by the SEC and FINRA (and do not have as onerous requirements as normal securities registration statements) so they may become an acceptable compromise distribution platform for both ICO sponsors and the SEC.

Report on The DAO

“The United States Securities and Exchange Commission’s (“Commission”) Division of Enforcement (“Division”) has investigated whether The DAO, an unincorporated organization; Slock.it UG (“Slock.it”), a German corporation; Slock.it’s co-founders; and intermediaries may have violated the federal securities laws.”

HFLB: the “sponsors” of The DAO were investigated, which is to be expected.  We find it interesting they used the word “intermediaries” which is probably intentionally vague.

“The automation of certain functions through this technology, “smart contracts,” or computer code, does not remove conduct from the purview of the U.S. federal securities laws. This Report also serves to stress the obligation to comply with the registration provisions of the federal securities laws with respect to products and platforms involving emerging technologies and new investor interfaces.” (citations omitted)

HFLB: pretty much what securities lawyers have been saying all along.

“From April 30, 2016 through May 28, 2016, The DAO offered and sold approximately 1.15 billion DAO Tokens in exchange for a total of approximately 12 million Ether (“ETH”), a virtual currency used on the Ethereum Blockchain.” (citations omitted)

HFLB: we believe that the SEC is saying here that Ether is not a security, but is instead a virtual currency.  This is important because it shows that some ICOs or digital assets (like ETH) can be instruments other than securities.

“The Commission is aware that virtual organizations and associated individuals and entities increasingly are using distributed ledger technology to offer and sell instruments such as DAO Tokens to raise capital. These offers and sales have been referred to, among other things, as “Initial Coin Offerings” or “Token Sales.” Accordingly, the Commission deems it appropriate and in the public interest to issue this Report in order to stress that the U.S. federal securities law may apply to various activities, including distributed ledger technology, depending on the particular facts and circumstances, without regard to the form of the organization or technology used to effectuate a particular offer or sale.”

HFLB: unfortunately looking to the “facts and circumstances” is all we have here – the SEC is not going to come out with a list of tokens they think our securities so we have to use the “sniff test” to determine whether any particular token is a security.  The best advice we have here is to look at the Coinbase Securities Law Framework to come up a best guess.

“The Platforms that traded DAO Tokens appear to have satisfied the criteria of Rule 3b-16(a) and do not appear to have been excluded from Rule 3b-16(b). As described above, the Platforms provided users with an electronic system that matched orders from multiple parties to buy and sell DAO Tokens for execution based on non-discretionary methods.”

HFLB: the SEC is putting those website where DAO Tokens were bought/sold on notice that they were operating as a securities exchange.  This will likely give unregistered crypto exchanges pause with respect to many digital asset instruments.

CorpFin / Enforcement Statement

“Market participants in this area must also consider other aspects of the securities laws, such as whether a platform facilitating transactions in its securities is operating as an exchange, whether the entity offering and selling the security could be an investment company, and whether anyone providing advice about an investment in the security could be an investment adviser.”

HFLB: the SEC makes reference to the mutual fund regulations (also applicable to private funds via 3(c)(1) and 3(c)(7) exemptions) as well as the investment advisor regulations, which are applicable to cryptocurrency fund managers.

“Although some of the detailed aspects of the federal securities laws and regulations embody more traditional forms of offerings or corporate organizations, these laws have a principles-based framework that can readily adapt to new types of technologies for creating and distributing securities.”

HFLB: this is exactly why we were surprised that the SEC has not previously issued guidance when it was clear there were other groups who have conducted ICO sales that clearly were securities offerings.  The SEC has had the opportunity (and, really, the obligation) to be enforcing the current securities laws in this space and the SEC has specifically chosen not to.  

“Finally, we recognize that new technologies also present new opportunities for bad actors to engage in fraudulent schemes, including old schemes under new names and using new terminology. We urge the investing public to be mindful of traditional “red flags” when making any investment decision, including: deals that sound too good to be true; promises of high returns with little or no risk; high-pressure sales tactics; and working with unregistered or unlicensed sellers.”

HFLB: we agree.  We fully expect to a number of frauds and other enforcement actions taken with respect to ICOs in the future.

Investor Bulletin

“Although ICOs are sometimes described as crowdfunding contracts, it is possible that they are not being offered and sold in compliance with the requirements of Regulation Crowdfunding or with the federal securities laws generally.”

HFLB: we believe that these various releases will ultimately push more ICOs to look toward crowdfunding platforms for their initial offerings.  We also believe that there is the possibility in the future for some sort of digital asset specific crowdfunding platform or a digital asset broker-dealer.

“Ask what your money will be used for and what rights the virtual coin or token provides to you.  The promoter should have a clear business plan that you can read and that you understand.  The rights the token or coin entitles you to should be clearly laid out, often in a white paper or development roadmap.  You should specifically ask about how and when you can get your money back in the event you wish to do so.  For example, do you have a right to give the token or coin back to the company or to receive a refund? Or can you resell the coin or token? Are there any limitations on your ability to resell the coin or token?”

HFLB: we believe this guidance is not really helpful for many ICO structures.  

“Fraudsters often use innovations and new technologies to perpetrate fraudulent investment schemes.  Fraudsters may entice investors by touting an ICO investment “opportunity” as a way to get into this cutting-edge space, promising or guaranteeing high investment returns.  Investors should always be suspicious of jargon-laden pitches, hard sells, and promises of outsized returns.  Also, it is relatively easy for anyone to use blockchain technology to create an ICO that looks impressive, even though it might actually be a scam.”

HFLB: we agree.  We believe it is highly likely there will be a number of scams that will be perpetuated through ICOs.

Conclusion

This is a first step of sorts toward more robust regulation of the digital assets.  Although we get some insight from the SEC, we don’t really see anything new and we don’t see how the SEC is going to protect the digital asset markets in the U.S.  Instead, this probably plays into fears that the U.S. is not a hospitable jurisdiction to novel ideas and structures and will ultimately push ICOs that would be based in the U.S. to offshore jurisdictions.  We hope the SEC uses these statements as a springboard to a dialogue with the industry to keep (and attract) innovators to the U.S.  More obviously forthcoming…

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For more information on this topic, please see our collection of cryptocurrency fund legal and operational posts.

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

Cryptocurrency Fund Legal & Operational Posts

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The goal of the posts on this page are to address the legal and operational issues applicable to fund managers who invest in the cryptocurrency space.  We believe the emergence of this new asset class gives rise to a need for open discussion of the protocols, operations, industry norms, and best practices (now and in the future) related to investments in this space.  Our goal is to help with that process and we look forward to hearing your feedback on these posts.

Fund Overview

Regulatory Items

Other Resources

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

California BitLicense

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Overview of the Cryptocurrency Licensing Regime in California

As we discussed in a recent post, New York has already implemented a statute that requires those engaged in certain virtual currency business activities to obtain a license from the state. In a similar fashion, California has proposed A.B. 1123 (the “Bill” or “Virtual Currency Act”)  that would allow the state to begin regulating the industry. This post focuses on California’s proposed version of a “BitLicense”, which like New York, would prohibit a person from engaging in a virtual currency business activity unless they receive a license from California’s Commissioner of Business Oversight (“Commissioner”).

California Virtual Currency Act – A.B. 1123

Pursuant to the Virtual Currency Act, any persons involved in a “virtual currency business” in California must register with the Commissioner.   The Act defines a “virtual currency business” as “maintaining full custody or control of virtual currency in this state on behalf of others.”  The definition of “virtual currency” is very broad (“any type of digital unit that is used as a medium of exchange or a form of digitally stored value”) although there are some carveouts for gaming platforms and for consumer reward programs.

The above definition seems to capture those groups who are offering exchange and wallet services for persons who are buying, selling and holding bitcoin and other digital currencies. Right now we don’t believe that a cryptocurrency hedge fund entity or its manager/general partner would need to obtain the license – a fund would simply be holding virtual currency on behalf of itself and therefore the general partner entity would not need to be registered.  

California Application Process

In the event an entity needs to register, there is an application process where the Commissioner will engage in an extensive review of the applicant’s background and services offered. California would also require an initial $5,000 application fee, a renewal fee of $2,500, and the maintenance of a minimum amount of capital as determined by the Commissioner. The licensee would be required to have an annual audit and would need to provide balance sheets, income statements, and other financial verification forms on a periodic basis.  A provisional license may be granted for a $500 fee to those engaged in a virtual currency business with less than $1,000,000 in outstanding obligations, and if the business model represents a low or no risk to consumers (as determined by the Commissioner). The provisional licensee may also be required to register as a money services business.

Looking Forward

As the definition of a virtual currency business is very broad, this Bill (like a predecessor bill which was abandoned) is heavily opposed by digital non-profit organizations, as well as many others in the space. It is yet to be seen whether this Bill will be passed or amended once again. However, the Bill’s reintroduction does demonstrate that lawmakers are still eager to regulate the industry. If passed, the Virtual Currency Act would become effective July 1, 2018. We will continue to follow the developments surrounding California’s Virtual Currency Act, and any potential impact this may have on investment managers in the state.

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

Bitcoin Hedge Funds (Cryptocurrency / AltCurrency Funds)

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Overview of Blockchain Based Digital Currency Investment Fund Structures

Bitcoin has recently been in the news again due to strong results over the last couple of months. Bitcoin and other digital currencies have been a bit of a fringe phenomenon in the investment management industry since inception. However, the power of the idea of distributed computing/ledgers has been evangelized in various parts of the tech industry and has attracted a significant amount of institutional investment into various digital currencies, and related infrastructure. It is not surprising then to see asset managers beginning to explore this space either through dedicated fund products, or through side pocket investments separate from more traditional products. This post discusses the various structural, regulatory, and operational issues that arise for managers who invest in these instruments.

Foundational Items – Definition

For purposes of this article, we make references to the term Bitcoin and digital currencies. These references will generally mean references to other blockchain-based currencies and/or digital tokens, which are sometimes referred to as cryptocurrencies or altcurrencies. There are various governmental agencies looking into how to define and regulate this space, and the CFTC has specifically defined the term “Bitcoin” in the following way:

Bitcoin is a “virtual currency,” defined here as a digital representation of value that functions as a medium of change, a unit of account, and/or a store of value, but does not have legal tender status in any jurisdiction. Bitcoin and other virtual currencies are distinct from “real” currencies, which are the coin and paper money of the United States or another country that are designated as legal tender, circulate, and are customarily used and accepted as a medium of exchange in the country of issuance. [See note 2 of the CFTC order discussed below.]

Another foundational item of this post is whether Bitcoin is a “security” under securities laws, or a currency under commodities laws, or both, or something else. We will discuss this issue in greater depth below under regulations, but for the general purposes of this article, we will take the position that Bitcoin is not a security regulated by the SEC nor state securities regulators. We will also take the position that Bitcoin is likely a currency that is subject (in some instances) to regulation by the CFTC.

Structural Considerations for Fund Formation

Although there are unique qualities of Bitcoin (it does not act like a security and it is debatable whether it acts like a commodity/currency), the big picture structural considerations for a fund manager in this space will not be significantly different than for a traditional hedge fund investing in securities and/or commodities.

• Hedge Fund or Private Equity Strategy. For the Bitcoin funds we have worked with, the strategies tend to be more hedge fund styled than private equity styled. This generally makes sense given the relatively “liquid” nature of the instrument. If a fund invests directly into operating companies in the digital currency ecosystem, or if a fund sets up operations to mine for Bitcoin, there may be the need for side-pocket private equity style sleeves within a larger liquid framework.

• Fund Terms. Normally we see standard hedge fund style terms; as well as expenses and fees that are generally similar to standard securities type fund programs (if anything, there may be greater management and performance fees because of the novel strategy / managers tend to have deep backgrounds in cryptography, mathematics and coding). Contribution provisions will also be standard. However, we tend to see greater attempts to limit withdrawals. Such measures could include longer withdrawal periods with longer notice provisions (60-90 days), and the use of investor level or fund level gates. Custody is a big issue, and valuation has the potential to be an issue as well. The use of leverage does not tend to be a major part of this investment strategy.

• Onshore / Offshore Structures. As with other non-traditional hedge funds, the structure will be influenced by the taxation of the underlying investments and the nature of the investors. As of right now, we are not aware of any adverse tax consequences with respect to digital currencies for U.S. based investors; therefore, a standard domestic Delaware limited partnership structure should be sufficient. If the fund will have U.S. tax exempt investors, the domestic structure should be sufficient if the fund does not utilize leverage. To the extent the tax code changes in the future to tax digital currencies specifically, the structural considerations may change.

If the fund complex intends to have non-U.S. investors, the manager will choose between a mini-master structure or a master-feeder structure. Jurisdiction of any offshore structure will likely be the Cayman Islands or the British Virgin Islands. We have not seen and do not necessarily believe there would be a reason for a fund complex to introduce SPV structures to accommodate digital currency investment, but if that occurred, such structuring discussions would be based on normal factors like jurisdiction of the underlying asset, corporate necessity, etc.

Regulatory and Other Considerations for Bitcoin Investment Managers

There are a number of instrument-related issues which arise for fund managers who are investing in this space. Because of the relatively nascent stage of these instruments, managers and service providers are working out the below issues, and the way these issues are handled should become more standardized in the near future.

• Federal & State Regulatory System.

SEC – Bitcoin and other digital currencies are most likely not securities; but, the SEC is currently examining how to deal with Bitcoin and other digital currencies. The biggest question is whether these instruments are securities or some other kind of asset subject to (or not subject to) regulation. If these digital currencies are securities, then the SEC will have jurisdiction to regulate the instruments, as well as the transfer of such instruments (including the regulation of any exchange facilitating such transfer). Because the SEC has not released any definitive guidance on the issue, Coinbase, a large Bitcoin wallet and exchange platform, has released the following discussion about how digital currencies fit into the SEC regulatory landscape (see Securities Law Framework for Bitcoin). Until we receive definitive guidance, or even informal guidance, from the SEC, the Coinbase framework discussion is probably the best reference material with respect to this particular issue.

CFTC – While it is clear that Bitcoin is fundamentally different from normal currencies traded on the Interbank or forex markets, what is less clear is whether and to what extent the CFTC has jurisdiction over the instrument and the exchanges on which they are traded on. Unfortunately, the answer is not exactly clear and the uncertainty, in part, comes from parts of the Dodd-Frank Act which provided the CFTC with new jurisdiction over parts of the currency trading systems in place in the United States. Because of certain the technical aspects of trading currencies both on the spot (interbank) and futures markets, and how those technical aspects inform the jurisdictional reach of the CFTC post Dodd-Frank, some part of this discussion is theoretical (what is delivery of a digital currency? what is custody of a digital currency and is this different from custody of a password?). While our law firm is currently in discussion with the CFTC as to whether a straight digital currency (as opposed to a digital currency forward or future) is a contract subject to CFTC jurisdiction, we currently believe that a private fund’s purchase of a Bitcoin or similar digital currency would not be subject to CFTC oversight (which would require the private fund manager to register as a CPO and CTA, or fit within exemptions). Notwithstanding the above, some types of instruments involving Bitcoin are commodities subject to CFTC oversight—please see Coinflip CFTC Order. In this order, there were a number of issues that led to the finding of regulatory oversight (products were deemed to be swaps; CFTC specifically mentioned OTC Bitcoin forward contracts as other contracts which may be subject to CFTC jurisdiction, see note 4).

CFTC and SEC? – In the future, it is likely that we will begin to see products linked to and based on Bitcoin, which have both the characteristics of a security and a futures product, thus subjecting such future instruments potentially to both CFTC and SEC jurisdiction. We would expect to see future legislation enacted both to define the nature of digital currencies, and any derivatives thereon, and also to define the scope of the CFTC and SEC’s jurisdiction over such products.

State – We have not heard of any state orders, actions or interpretations involving Bitcoin. We would expect the regulation of such assets to be driven by federal authorities, but we do not discount the fact that many state securities regulators (especially on the west coast) can take aggressive positions regarding new products.

• Regulation of Management Company. Depending on where the manager fits within the regulatory spectrum discussed above, the manager may be subject to oversight and regulation. If the manager is deemed to be an investment adviser, or CTA and/or CPO, based on the above, the manager would be subject to the normal registration and compliance frameworks associated therewith. Managers who invest in other Bitcoin or cryptocurrency funds are definitely investing in securities (a private fund is a security), so a bitcoin fund of funds manager is deemed to be an investment adviser and would need to be registered (or fall within an exemption from registration) with the SEC or state securities commission. While we have seen some significant investment into the space, we acknowledge that the sector is still in its infancy and that we will probably begin to see more institutionalization among managers in this space.

• Custody. Perhaps the biggest issue with respect to these instruments is how and where they are custodied, and also how and where the passwords, keys or other information related to the proof ownership are custodied. We believe that each manager needs to develop their own methods to deal with the custody issue, and that these methods will need to address the associated risks of ownership or the particular currency (as discussed in the Securities Law Framework for Bitcoin, each instrument has unique characteristics). In addition to the managers we have worked with, we have heard anecdotal stories about the many different ways managers store and protect the fund’s ownership and evidence of ownership of the digital currencies, including the use of thumb drives and bank safety deposit boxes.

• Risks. A fund in this space will need to focus of the normal risks inherent for any private investment vehicle, but there are additional risks to consider related to the strategy, including: general risk of digital currencies, liquidity, ability to hedge, volatility, loss of private keys, technology and security issues, risk of exchanges (e.g. Mt. Gox), lack of FIDC or SIPC protection.

• Service Providers. The typical service providers in this space (lawyers, administrators and auditors) have been working together to figure out how to deal with the novel and unique issues presented from these instruments.

• Other Issues. There are a host of other issues which arise in this space that will continue to be flushed out over time. These include IT infrastructure for managers and general security over passwords. Valuation has the potential to be an issue depending on the exact nature of the digital currency, and whether the currency is fungible and traded on different exchanges that have different pricing. Valuation also may be an issue if it is determined that there is no public market or exchange for the instrument. Taxation of the gains on these instruments may also change in the future (right now, they presumably are taxed under IRC Section 988). Additionally, there may be capacity constraints as a large number of investors begin to pile into these investments, including when the derivatives markets take hold.

Conclusion

We have worked with a number of groups in this space over the past two years, and have seen an uptick in interest in managing a private fund to invest in Bitcoin and digital currencies. We believe the interest stems from the strong returns of Bitcoin, as well as the public’s growing acceptance of alternative currencies. We also think that a general increase in exposure of Bitcoin has contributed to an interest in being able to invest in digital currencies. As these investments become more standardized and regulated, we believe we will continue to see growth in this area.

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