Tag Archives: digital asset regulation

Cole-Frieman & Mallon 2021 Half Year Update

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July 13, 2021

Clients, Friends, Associates:

We hope that this message finds you well and that you are enjoying the first months of summer. As we move into the third quarter, we would like to provide you with a brief overview of some items that we hope will help you stay on top of the business and regulatory landscape in the coming months. We are also delighted to report our firm and Co-Managing Partner, Karl Cole-Frieman, were highlighted as leading crypto and blockchain lawyers by Business Insider. For additional firm updates, please follow us on LinkedIn. 

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SEC Matters

SEC Revises Qualified Client Threshold. The SEC recently published an order approving adjustments to the tests which define a “Qualified Client” under the Investment Advisers Act of 1940, as amended (the “Advisers Act”). Specifically, the “net worth” threshold has been increased from $2,100,000 to $2,200,000 and the dollar amount for the “assets-under-management” test has been raised from $1,000,000 to $1,100,000. The Qualified Client threshold is critically important for investment advisers because in nearly all jurisdictions, including for SEC registered investment advisers, performance fees and incentive allocations can only be charged to investors who are Qualified Clients. The new definitions become effective August 16, 2021 (the “Effective Date”), but will not be applied retroactively to contractual relationships existing as of such date. Additionally, an investor who satisfied the previous Qualified Client test and who subscribed for interests in a private fund prior to the Effective Date will remain subject to any applicable performance fees, and may make additional subscriptions (subject to performance fees) without needing to satisfy the new threshold amounts.

All investment advisers should promptly update their subscription documents to ensure that new investors who agree to make investments on or after the Effective Date have provided accurate representations regarding their Qualified Client status.

SEC adopts Marketing Rule (replaces Advertising Rule and Cash Solicitation Rule). On May 4, 2021, the SEC adopted new marketing rules for investment advisers. The new rules drastically overhaul and replace the prior cash solicitation and advertising rules applicable to investment advisers, their marketing materials, and their advertising practices to replace. SEC no-action letters pertaining to the prior cash solicitation rule will be nullified as the rule is being rescinded in practice. The most significant changes include the allowance of testimonials and endorsements, which under the prior rules were conditionally permitted to be used in advisers’ marketing materials. The new marketing rule now permits such use only if the adviser complies with specific disclosure, oversight, and disqualification provisions. Third-party ratings are now also permitted, though, just like testimonials and endorsements, they are subject to detailed disclosure and other presentation criteria.

The new marketing rule also overhauls how investment advisers can utilize social media. The SEC created concepts of “adoption” and “entanglement” with respect to posts on social media and, depending on whether an investment adviser has “adopted” a social media post or “entangled” itself in one, there are a series of rules applicable to each such post. More importantly, social media posts of persons associated with an investment adviser can also be viewed as the investment adviser’s communication or advertisement. Thus, investment advisers should adopt policies and procedures which distinguish their associated persons’ personal social media posts from those of the investment adviser. 

Specific rules and guidance now apply to various types of performance advertising, including gross, net, hypothetical, related, and extractive performance. Many of these rules now codify prior SEC no-action letter guidance on these topics. 

Investment advisers have some room to breathe since the compliance period for these new marketing rules begins on November 4, 2022.

SEC Brings Action for Defrauding Investors in Scheme Involving Pre-IPO Shares. On April 27, 2021, the SEC charged a former broker barred by FINRA with fraudulently raising funds. The complaint alleges that the defendant solicited investors by claiming to purchase shares of notable “unicorn” companies prior to their initial public offerings. However, the defendant failed to invest the funds and instead stole the money, using it to pay family members and purchase a Maserati. The defendant is charged with violating the antifraud provisions of Section 10(b) of the Securities and Exchange of 1934 and Rule 10b-5 thereunder and Section 17(a) of the Securities Act of 1933. 

SEC Announces Partially Settled Charges After Investment Adviser Fails to Report Bad Investments. On April 15, 2021, the SEC filed a complaint against the co-founder and COO of an investment adviser for violating the anti-fraud provisions of the Securities Exchange Act of 1934 and the Securities Act of 1933. The SEC alleges the defendant defrauded hedge fund clients by creating fake “performing” loans to replace defaulted loans in order to hide losses. The SEC further alleges that the defendant created liquidity or met redemption requests by selling overvalued loans to new investors to pay off earlier investors. Collectively, the series of fraudulent acts hid tens of millions of losses. The SEC has already obtained final judgement against the investment adviser itself, requiring it to pay in excess of $35 million in prejudgement interest and disgorgement.

SEC Brings Action for Failure to Follow Stated Investment Criteria. In a recent enforcement action, the SEC has alleged that a Texas-based registered investment advisor (“RIA”) defrauded investors by failing to follow stated investment criteria. The complaint alleges that the principal along with its investment adviser representative (“IAR”) targeted older and unsophisticated investors with promises of high returns from secure investments in “proven” companies which met the firm’s stated investment criteria. However, the complaint goes on to allege that the firm only invested in high-risk and fraudulent companies which were affiliated with and owned by the firm’s principal and/or his older brother. The SEC alleges that this Texas-based RIA made materially false and misleading statements to investors about expected financial returns and the financial health of these companies. Moreover, the principal and his older brother allegedly falsified the financial documents of their companies to inflate their assets, misused funds for their own benefit, failed to make adequate disclosures of the conflicts of interests, failed to comply with rules governing the custody of client assets, and overall violated federal securities laws, including antifraud provisions. The SEC is seeking permanent injunctive relief, disgorgement of ill-gotten gains plus prejudgement interest, civil penalties, and any equitable and ancillary relief deemed necessary by the court.

SEC Obtains Asset Freeze After Uncovering Cherry-picking Scheme. On June 17, 2021, the SEC announced that it obtained an asset freeze and filed fraud charges in connection to a cherry-picking scheme where a Miami-based investment professional and two investment firms allegedly funneled trading profits to preferred accounts. The complaint alleges defendants engaged in a long-running fraudulent trade allocation scheme. Approximately $4.6 million in profitable trades were allocated to accounts held by relatives of the defendants while several other investment advisory clients bore first day losses totaling more than $5.5 million. This investigation originated in the Market Abuse Unit’s Analysis and Detection Center, which uses data analysis to detect suspicious activity such as impossibly successful trading. The SEC is currently seeking permanent injunctions, disgorgement, prejudgment interest, and civil penalties. It also intends to recover any unlawful gains and prejudgment interest from the preferred accounts.

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Digital Asset Matters

Update on BitMEX Lawsuit. On October 1, 2020, the Department of Justice filed a criminal complaint against specific individuals associated with BitMex for violating and conspiring to violate the Bank Secrecy Act. The CFTC also filed a civil complaint against BitMEX, alleging failure to register with the CFTC and violation of various laws and regulations under the Commodity Exchange Act. Both actions are pending in the U.S. District Court for the Southern District of New York. On February 10, 2021, the Department of Justice intervened in the CFTC case and sought a stay of discovery pending the criminal case’s resolution. On February 11, the CFTC submitted a letter not to oppose the DOJ’s stay. On March 24, United States District Judge Mary Kay Vyskocil granted the motion to permit the DOJ to intervene in the CFTC case for the purpose of seeking a stay of discovery, further noting that the DOJ is permitted to file a motion to stay discovery after the defendants have responded to the complaint. Both cases remain pending. These two lawsuits signal that the DOJ and the CFTC has and will continue to monitor the digital asset market. 

SEC Files Action Against Ripple for Unregistered Securities Offering. In December 2020, the SEC filed an action against Ripple Labs Inc. (“Ripple”) and two of its executives in the U.S. District Court for the Southern District of New York, alleging that they raised over $1.3 billion through an unregistered, ongoing digital asset securities offering. The SEC’s case rests on the proposition that XRP is a security because investors who purchased XRP anticipated that profits would be dependent upon Ripple’s efforts to manage and develop the market for XRP. The case remains pending. The outcome of this lawsuit, although uncertain at this point, may have significant impact on the future regulation on cryptocurrencies and blockchain technologies.

South Korea to Introduce 20% Tax on Crypto Trading Profits. South Korea will implement a 20% capital gains tax on Bitcoin (BTC) and cryptocurrency profits starting January 1, 2022. The tax is expected to be triggered when profits exceed 2.5 million Won, with gain made up to this point being tax-exempt.

Yield Farming Strategies. As decentralized finance (“DeFi”) applications continue to develop, the interest in yield farming has grown exponentially. At a high level, the goal of yield farming is to maximize returns by leveraging various DeFi protocols, and this can be done in a few different ways. To employ a yield farming strategy, a liquidity provider essentially locks its digital assets in a liquidity pool (where users can lend, borrow, or exchange tokens), thus providing liquidity to that pool. In return, the liquidity provider receives an annual percentage return. Liquidity mining, a type of yield farming, provides liquidity providers with reward tokens on top of that annual return. Liquidity providers can then deposit reward tokens into other liquidity pools to earn more rewards and repeat this process countless times. To increase the potential return of an investment, yield farmers can also deposit tokens as collateral to a liquidity pool, then use the borrowed tokens as further collateral to then borrow more tokens, and so on. It is important to note that if a position becomes undercollateralized, there is a risk that the DeFi protocol may liquidate the collateral which could result in a total loss to the liquidity provider. While the potential of impressive returns is enticing, those interested in yield farming strategies should consider the many risks inherent in such strategies, including impermanent loss, price slippage, smart contract code bugs leading to hacks or fraud, “rug pulling” scams, as well as the risk of under collateralization, which can incidentally result from price movements of the borrowed token.

El Salvador Adopts Bitcoin Legal Tender. On June 8, 2021, the Salvadorian Congress approved new legislation, making it the first country to adopt Bitcoin as legal tender. “The purpose of this law is to regulate Bitcoin as unrestricted legal tender with liberating power, unlimited in any transaction, and to any title that public or private natural or legal person require carrying out,” the law reads. Under the new law, prices can be displayed in Bitcoin, taxes can be paid in Bitcoin, and transactions conducted using the digital currency will not be subject to a capital gains tax. The exchange rate with the U.S. Dollar (El Salvador’s current official currency) will be established by the market. The law also adds that the Salvadorian government will implement trainings and other mechanisms to ensure that its citizens can access Bitcoin transactions.

DeFi “Raises Challenges” for Investors, Regulators, SEC’s Gensler Says. In a written testimony before the House Appropriations Committee, SEC Chairman Gary Gensler discussed the challenges posed by decentralized finance. Examples of the challenges of DeFi given include market volatility and novel product offerings. Gensler’s concerns surrounding DeFi did not come as a surprise. In January, SEC Commissioner Hester Peirce offered the following quote: “It’s going to be challenging to us because most of the way we regulate is through intermediaries and when you really build something that’s decentralized, there’s no intermediary…. It’s great for resilience of a system but it’s much harder for us when we’re trying to go in and regulate to figure out how to do that”. Gensler has also previously suggested establishing a dedicated market regulator for cryptocurrency in order to provide protection against market manipulation and fraud. As DeFi continues to grow, it will be interesting to watch regulator’s approach to DeFi as it may have a large impact on the emerging space. 

SEC Petitioned on NFTs as NFT Platform is Sued in Class Action. On April 12, 2021, a broker-dealer registered with the SEC and FINRA issued a petition to the SEC, calling for a concept release of regulations for nonfungible tokens (NFTs) and rules addressing when NFTs are considered securities. The petitioner notes that the existing definition of a security does not explicitly include NFTs, but NFTs that promise a “return on investment from the efforts of others”, could be deemed a security under the Howey test. The petitioner further clarifies that if an NFT “relates to an existing asset and is marketed as a collectible with a public assurance of authenticity on the blockchain, it should not be deemed a security.” To date, the SEC has not issued interpretive guidance on NFTs and has not initiated any enforcement actions against an NFT creator or NFT trading platform.

This petition arrives as Dapper Labs, the creator of the popular NFT marketplace NBA Top Shot, faces a class action lawsuit. The plaintiffs assert that NBA Top Shot’s “moments”, NFTs sold as collectable video highlights, are securities. These allegations center on the argument that moments increase in value as NBA Top Shot rises in popularity, therefore satisfying the Howey Test. The complaint also alleges that Dapper Labs has controlled the marketplace in way that prevents users from “cashing out” their purchases, keeping their value artificially high. It will be interesting to see how these issues are resolved by the SEC and the courts, as if NFTs are determined to be a security either by the SEC or the courts, NFT marketplaces and issuers may be forced to register with the SEC.

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CFTC Matters

Changes for Form CPO-PQR. Beginning with the March 31, 2021 reporting date, a revised and streamlined Form CPO-PQR will be used based on recent CFTC amendments. The revised Form CPO-PQR has been reduced to one schedule (Schedule A), and all reporting commodity pool operators (“CPOs”) will file the revised Form CPO-PQR every quarter, regardless of size. Technical updates have also been made, which make the form easier to fill out. 

Default Judgment Entered Against Operator of Cryptocurrency Pool. On March 29, 2021, the U.S. District Court for the District of Nevada entered a default judgement against an Australian national and his Nevada corporation in connection with a cryptocurrency fraud and misappropriation scheme. The court concluded that the defendants made false claims about the individual’s trading acumen and baselessly guaranteed high rates of return in soliciting investors into a pool operated by the Nevada corporation. The pool engaged in off-exchange binary options trading on forex and cryptocurrency pairs; however, the defendants also stole participants’ funds and comingled assets in the individual’s personal cryptocurrency wallet. Additionally, the defendants effected a Ponzi scheme by paying investor redemptions with funds from other investors. Although the default judgment orders the defendants to pay restitution, disgorgement of profits and penalties totaling more than $32 million, the CFTC cautions investors that such order does not guarantee participants a full recovery.

CFTC Establishes Climate Risk Unit. In March, Acting CFTC Chairman Rostin Behnam announced the establishment of the Climate Risk Unit (“CRU”), which will assess the efficacy of derivatives products in addressing climate and weather-related risks in the financial system. Also, in an effort to reduce carbon emissions world-wide, the CRU will represent the CFTC in industry discussions in furtherance of this mission. The CRU also intends to, inter alia, facilitate dialogue regarding emerging climate risks, develop new products to help transition to a “net-zero” economy, support development of climate-related market risk data, and evaluate the utility of other tools (e.g., regulatory sandboxes) in accelerating such products and services.

NFA’s New Notice Requirements for CPOs Became Effective as of June 30, 2021. The NFA’s newly adopted Compliance Rule 2-50 requires CPOs to notify the NFA upon the occurrence of certain events such as a commodity pool’s ability to fulfill its obligations to investors or a potential unplanned liquidation of the pool. CPOs are now required to notify the NFA if they: (1) operate a pool that cannot meet a margin call, (2) operate a pool that cannot satisfy redemption requests in accordance with their subscription agreements, (3) operate a pool that has stopped redemptions unrelated to existing lockups or gates, and pre-planned cessation of operations or (4) receive notice from a swap counterparty that a pool operated by the CPO is in default. This rule applies to all pools operated by a CPO, including pools that meet the “de minimis” threshold pursuant to CFTC Regulation 4.13(a)(3). Generally, notice of a specified event must occur no later than 5:00 pm CT of the next business day; provided that, Interpretive Notice 9080 gives examples of when notice is not required (e.g., if a CPO reasonably expects to meet the margin call within the time prescribed by its FCM).

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Other Matters

Corporate Transparency Act Requires Disclosure of Ownership Information of Certain Entities. Overriding President Trump’s veto, Congress enacted the National Defense Authorization Act for Fiscal Year 2021 on January 1, 2021, which, among other things, includes the Corporate Transparency Act (the “CT Act”) requiring certain ‘reporting companies’ to report their beneficial ownership information to the Financial Crimes Enforcement Network (“FinCEN”). Today, the CT Act excludes from the definition of ‘reporting companies’ registered investment advisers, venture capital fund advisers that file Form ADV, and private investment funds advised by investment advisers and identified by name on such advisers Form ADV. However, investment advisers relying on the private fund exemption are not exempt from the CT Act and, absent changes in the regulations adopted by the U.S. Treasury, will be required to report their beneficial ownership information to FinCEN. The CT Act goes into effect on the date regulations are issued by the U.S. Treasury, which shall occur no later than January 1, 2022. FinCEN is currently soliciting public comment on questions about the new reporting requirements.

Executive Orders Prohibit the Purchase of Publicly Traded Communist Chinese Military Company Securities by U.S. Persons. President Trump signed Executive Order 13959 on November 12, 2020, and subsequently amended it with Executive Order 13974 on January 13, 2021, to prohibit the purchase of publicly traded Communist Chinese Military Company (“CCMC”) securities, including securities that are derivative of or designed to provide investment exposure to such CCMC securities. The orders prohibit the purchase by U.S. persons of any such securities beginning 60 days after an entity is designated as a CCMC, and require U.S. persons to divest from those securities within one year of such designation. Therefore, for the CCMCs initially designated on November 12, purchase of such securities was prohibited beginning January 11, 2021, and all U.S. persons must divest by November 11, 2021. While the Office of Foreign Asset Control has issued an FAQ clarifying the orders, neither the orders nor the FAQ provide clarity on whether U.S. persons must divest from foreign private funds that hold CCMC securities, and it remains to be seen if the new administration will seek to amend the order before divestment is required. A list of entities designated CCMCs as of June 16, 2021 can be found here.

New York Eliminates Pre-Offer Filing Requirements for Rule 506 Offerings under Regulation D. The New York Attorney General announced on December 1, 2020, an amendment to New York’s antiquated and controversial securities regulations applicable to offerings made under Rule 506 of Regulation D. The old rule required issuers to file a Form 99 prior to any sale or offering of such “covered securities” in the state. Beginning on December 2, 2020, the updated rule eliminated the Form 99 requirement and provided that notice filings shall be made within 15 days following the date of the first sale of applicable securities via the North American Association of Securities Administrators electronic filing depository system. The filing fee continues to be based on the offering amount and is unchanged from the fees required prior to the adoption of the new rule.  

Registration of New York IARs. Starting February 1, 2021, IARs who engage in business within or from New York and principals or supervisors of New York-state registered investment advisers must register with the New York Investor Protection Bureau (the “NYIPB”) by filing a Form U4 or updating an existing Form U4, and must also meet certain exam requirements. IARs with a place of business in New York that represent SEC-registered investment advisers that notice-file in New York must also register with the NYIPB. The new regulations grant IARs operating in New York prior to February 1, 2021, a grace period to submit their Form U4 until August 31, 2021, and such IARs may continue such service without an approval until December 2, 2021.

Employers can Inquire about the Vaccination Status of Employees. On May 28, 2021, the U.S. Equal Employment Opportunity Commission (“EEOC”) updated its guidelines on the COVID-19 vaccine and Americans with Disabilities Act (“ADA”) compliance. The guidelines reaffirmed the EEOC’s previous position that employers can ask their employees whether or not they have received the COVID-19 vaccine but added that any vaccination status documentation must be kept confidential and stored separately from the employee’s personnel file. It is recommended for employers to only ask for the bare minimum, such as a vaccination card or survey response, to prevent employees from providing additional medical information and implicating the ADA. Additionally, employers can “encourage” employee vaccinations by providing information on approved vaccines, addressing common questions and concerns, or by offering incentives to employees who receive the vaccine. As of the date of publication, there are no examples of states passing laws conflicting with EEOC guidance, but this may change as companies continue to return to the office.

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Compliance Calendar

Please consult our Compliance Calendar for key dates as you plan your regulatory compliance timeline for the coming months and contact us with any questions for assistance with any of the above topics.

We wish you and yours a safe and healthy summer.

Sincerely, Karl Cole-Frieman, Bart Mallon, Lilly Palmer, David Rothschild, & Scott Kitchens

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Cole-Frieman & Mallon LLP is one of the top investment management law firms in the United States, known for providing top-tier, innovative, and collaborative legal solutions for complex financial services matters. Headquartered in San Francisco, Cole-Frieman & Mallon LLP services both start-up investment managers and multi-billion-dollar firms. The Firm provides a full suite of legal services to the investment management community, including hedge fund, private equity fund, venture capital fund, mutual fund formation, adviser registration, counterparty documentation, SEC, CFTC, NFA and FINRA matters, seed deals, hedge fund due diligence, employment and compensation matters, and routine business matters. The Firm also publishes the prominent Hedge Fund Law Blog, which focuses on legal issues that impact the hedge fund community. For more information, please add us on LinkedIn and visit us at colefrieman.com.   

Recap of Crypto Discussion Forum

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On September 2nd we held our crypto discussion forum where we discussed legal, tax and compliance issues related to the digital asset space. The below is a quick recap the event from panelist Justin Schleifer of Aspect Advisors. We’ll keep updating everyone through this blog on future events as well.

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Thank you for attending our “Cryptocurrency and Digital Asset Forum: Trends in Legal, Tax, and Compliance” webinar last week. I would also like to extend many thanks to my fellow panelists, Ryan David Williams of Ashbury Legal and Nick Cerasuolo of Blockchain Tax Partners, and to Bart Mallon of Cole-Frieman & Mallon for hosting.

We had a very interesting and lively interactive discussion about putting crypto investments to work through yield and lending, and DeFi implications including market-making, governance and custody issues.

Here are my favorite tidbits from the various speakers:

Each state has their own regulations as well, and everyone is on different parts of the learning curve. People have to address the nuances of each individual state. States may not agree with the idea of a custodian. DeFi is just way out there for them. They’re still on this idea of what is a custodian in the crypto space? Just getting over that hurdle has proven to be very difficult. – Bart

With the advent of crypto/blockchain, we almost went back in time because are used to dealing with USD. It’s obvious when something is taxable. Crypto took us back to the stone age where we’re back to barter model; property for property (BTC for ETH). You have transactions that don’t involve fiat at all. Tax event triggers are traps for the unwary. It’s not always obvious when a transaction is taxable. – Nick

Insider trading is absolutely an issue in this industry, and it’s getting more nuanced. Firms in the venture capital space get involved with companies on working on their protocols and Dapps. You can very well come in contact with all types of MNPI, so both sides must evaluate what is material or public. You have to restrict yourself in certain areas and not commit to certain trading activities. – Justin

There was a fantasy that once you achieve decentralization, laws are gone. This is an ethos that a decentralized exchange doesn’t need KYC/AML. We are now dispelled of that notion (i.e. the SEC went after the founder of a crypto exchange). The CFTC has also said they will go after software developers. This is the concept of causing a violation of securities law. The expectation of profits is based on the efforts of others. The manager is doing all the work, but what do we do when there is no sponsor and the work is done by community participants? We haven’t finalized this yet. ETH is officially decentralized, so it doesn’t make sense to apply traditional securities laws. – Ryan

If you (or your friends or colleagues) would like to review any of the webinar content, please email Amanda Brown for a link to the recording. If you have any questions about any of the above topics, please reach out to any of our panelists.

We hope you enjoyed this event and if you have any feedback, we would love to hear from you. We look forward to seeing you at our next event!

Best regards, Justin Schleifer

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

Cryptocurrency / Digital Asset Forum – Ask us your questions!

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Open Forum on September 2nd for Legal, Tax & Compliance Questions

There are a ton of hot topics in the digital asset space right now – the price of Bitcoin, DeFi, staking, lending, venture capital, etc – and we want to answer your questions in a unique format where the experts answer your questions directly.  Our firm is teaming up with Asbury Legal, Aspect Advisors and Blockchain Tax Partners to host a live discussion where we will talk about what you want to talk about.

To register for webinar, please go here.

To submit a question, please go here. 

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September 2, 2020 10:00am Pacific / 1:00pm Eastern

The Host: Bart Mallon, Cole-Frieman & Mallon as Host

The Panel:

Ryan David Williams, Ashbury Legal

Justin Schleifer, Aspect Advisors

Nick Cerasuolo, Blockchain Tax Partners

Join us to get your questions answered by an expert panel during a Live Discussion. Experience a unique collaborative event to explore the latest developments in the Cryptocurrency and Digital Asset sector. Suggested topics for this session include (but are in no way limited to):

•    Putting Crypto Investments to Work:  Unlocking Full Potential Through Yield and Lending

•    DeFi Implications: Market-Making (Liquidity), Governance, and Custody

•    Evolving Landscape: Latest Products/Services, Regulations, and Enforcements

Submit your questions in advance and we’ll have answers prepared.   You’ll also be able to ask questions during the interactive discussion.  We’re excited to talk about anything you want!

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Bart Mallon is a founding partner of Cole-Frieman & Mallon LLP. Cole-Frieman & Mallon is a boutique law firm focused on providing institutional quality legal services to the investment management industry. For more information on this topic, please contact Mr. Mallon directly at 415-868-5345.

Bitcoin Mining Panel Event in San Francisco

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CFM & Aspect Advisors Sponsor Mining Discussion

As the price of bitcoin (and other digital assets) rises, the economics of mining changes – we plan to have an event to explore the economics of mining and other aspects of the industry including any digital asset compliance matters. Below is the invitation. If you are interested in attending or would like to see the notes on the event, please contact us.

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Please see attached an invitation to attend a discussion on the current environment for bitcoin mining.  This event is presented by Michael Fitzsimmons of Williams Trading and sponsored by Cole-Frieman & Mallon LLP and Aspect Advisors LLC.

This event will feature the following panelists:

  • Mathew D’Souza of Blockware Solutions
  • Thomas Ao of MCredit
  • Yida Gao of Struck Capital

Location is at Cole-Frieman & Mallon LLP offices – 255 California Street, Suite 1350. 

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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 us or you can call Mr. Mallon directly at 415-868-5345.

Cole-Frieman & Mallon 2019 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 you had an enjoyable summer. Typically, the third quarter is quieter than the second quarter from a compliance perspective, however we continue to see meaningful enforcement actions taken by regulatory authorities and rapid developments in the digital asset space. Entering the fourth quarter, we would like to highlight some items we hope will help you stay on top of the business and regulatory landscape in the coming months.  But first, a couple of items of firm news:

  • CoinAlts Fund Symposium. In September, In September, founding sponsor CFM broke new ground to host its fourth successful Symposium in Chicago. An impressive line-up of speakers addressed pressing issues for institutions in the digital asset ecosystem, including legal and operational concerns for fund managers, recent trends and innovations in blockchain, and raising capital from institutional allocators.
    • Cole-Frieman & Mallon’s Anniversary. On September 17th CFM celebrated with family, friends, colleagues and clients 10 years of successful growth to become the largest hedge fund practice in the West Coast. We very much appreciate the continued support from our clients and friends in the industry and look forward to the next decade of success.

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Privacy Regulations

Cayman Islands Data Protection Law Effective September 30, 2019. The Cayman Islands Data Protection Law, 2017 (“DPL”) became effective on September 30, 2019 and applies to all investment advisers providing investment advice to Cayman Islands funds. Under the DPL, Cayman investment funds are considered “data controllers” whether or not they are registered with the Cayman Islands Monetary Authority and investment advisers to such funds are considered “data processors.” The DPL requires data controllers to update their Cayman fund’s subscription agreements to include language specific to the DPL and otherwise provide investors with an updated DPL-compliant privacy notice. There is no specific deadline to provide investors with such privacy notice. Fund administrators must also ensure that they are DPL-compliant and updates to the fund’s administration agreement may be required.

California Consumer Privacy Act to be Effective January 1, 2020. The California Consumer Privacy Act (the “Act”) was passed into California law on June 28, 2018 and will be effective on January 1, 2020. The Act will not apply to most fund managers and will generally only impact managers that serve California residents and have at least $25 million in annual gross revenue, have personal data on at least 50,000 Californians, or receive over half their revenues from the sale of personal data of California residents. The Act does not apply to current client data and, on October 11, 2019, Governor Newsom signed seven amendments into law that generally limit the Act’s reach even further. If the Act were to apply to a fund manager, to be in compliance, such fund manager should post a privacy policy on its website disclosing its collection of personal information, maintain an organized data collection process, and provide investors information regarding the use of their information and the right to opt-out of the sale and request the deletion of such information.

New York SHIELD Act Heightens the State’s Privacy Regulations. On July 25, 2019, the Stop Hacks and Improve Electronic Data Security Act (the “SHIELD Act”) was signed into New York law and amends the State’s data breach notification law. The SHIELD Act, which is set to take effect in March 2020, requires certain businesses or individuals implement safeguards to protect the security, confidentiality and integrity of information. The SHIELD Act broadens the definition of “private information” to include credit card or debit card numbers, usernames and passwords (or security questions and answers) used to access an individual’s online accounts, and biometric information, like fingerprints. The SHIELD Act also expands the definition of “breach”, from unauthorized acquisition of private information to include unauthorized access to private information, as well as the scope of the breach notification requirement to include any person or business that owns or licenses private information of a New York resident. This means the law is no longer limited to those conducting business in New York, but could affect managers who, for example, only store a New York investor’s private information. Because of the broad scope of the SHIELD Act, managers who own private information of a New York resident should review the updated security requirements the Act imposes on them, including the need to implement a data security program, as more specifically discussed in the SHIELD Act.

SEC Matters

SEC Publishes Risk Alert on Principal and Agency Cross Trading Compliance Issues. On September 4, 2019, the Securities and Exchange Commission (“SEC”) published a Risk Alert advising readers on common compliance issues identified in investment adviser examinations, related to principal and agency cross transactions under Section 206(3) of the Investment Advisers Act of 1940, as amended (the “Advisers Act”). These transactions occur when investment advisers execute client transactions as a broker or dealer, either acting as a broker or dealer for its advisory client or doing so for both its advisory client and its brokerage client on the other end of the same transaction. The examinations the SEC conducted showed advisers either did not know they had engaged in principal trades or did not disclose or obtain the required consent before completing the transactions. With respect to agency cross transactions, the examinations also showed advisers often engaged in agency cross transactions without properly disclosing this to clients or could not show proof they had complied with the applicable consent or disclosure requirements. The Risk Alert also expressed concern that many advisers engaging in these transactions either did not have proper compliance policies and procedures or failed to follow the policies and procedures that had been established. Advisers should look closely at potential transactions to determine whether they qualify as either principal trades or agency cross transactions and if so, what actions need to be taken to comply with the respective requirements.

SEC Charged RIA for Nondisclosure of Conflicts Arising from Revenue Sharing. On August 1, 2019, the SEC  charged an SEC RIA for failure to disclose conflicts of interest relating to a revenue sharing agreement with the broker used by most of its clients. The revenue sharing agreement provided that, if the adviser invested its client assets in certain classes of mutual funds that paid the broker to be listed on its platform, the adviser would receive a portion of those payments. The adviser received over $100 million from the broker from July 2014 to December 2018 because of this arrangement. However, the adviser never disclosed to its clients that there were other mutual fund investments less expensive than the investments subject to the revenue sharing agreement. The SEC considered these to be material omissions and determined the adviser’s clients did not make these investments with full knowledge of the adviser’s incentives. Fund managers should ensure that all pertinent conflicts of interest, including those related to the receipt of compensation from third parties, are properly disclosed to their clients.

FINRA Matters

FINRA Proposes Changes to Restricted Person and Spinning Provisions.  On July 26, 2019, FINRA, along with the SEC, proposed certain amendments to FINRA Rules 5130 and 5131. One of the amendments would exempt certain additional persons and certain types of offerings from the scope of the rules. Among other changes (eight total), the proposals would (i) include the definitions of “family member” and “family client” as defined under the Advisers Act in the definition of “family investment vehicle” under Rule 5130, (ii) exempt foreign employee retirement benefit plans that meet certain conditions from Rules 5130 and 5131 and (iii) exclude unaffiliated charitable organizations from the definition of “covered non-public company” in Rule 5131. If these changes are approved and become effective, fund managers can expect further regulatory consistency and clarity to result.

Digital Asset Matters

Bakkt Announces that it’s “Cleared to Launch” Bitcoin Futures. Bakkt, a bitcoin futures exchange and digital assets platform founded by the Intercontinental Exchange (“ICE”), announced in mid-August that the CFTC gave its go-ahead for Bakkt’s futures contracts. The announcement discussed that Bakkt’s bitcoin futures would be exchange-traded on ICE Futures U.S. and cleared on ICE Clear US, both of which are regulated by the CFTC. Bakkt further announced that it acquired a New York state trust charter through the New York State Department of Financial Services, and that this approval to create Bakkt Trust Company, a qualified custodian, would allow the Bakkt Warehouse, which is part of Bakkt Trust Company, to provide bitcoin custodial services for physically delivered futures. On September 23, 2019, Bakkt launched its custody and physically-settled bitcoin futures contracts products. Many disagree whether the launch, which had a trade volume during the first seven days of $5.8 million, was successful or not, and certain researchers speculate the launch was partially why bitcoin’s price has recently decreased. Despite this, the news of the launch can potentially benefit fund managers as Bakkt aims to provide access to this market and address issues that have slowed institutional participation in this market in the past.

SEC Delays Decision on Three Bitcoin ETFs. On August 12, 2019, the SEC once again delayed a decision on three bitcoin ETF proposals.  As of yet, the SEC has not approved a bitcoin ETF. In previous decisions, the SEC expressed concerns with market manipulation, market surveillance and a possible divergence with futures trading. One of the entities proposing a bitcoin ETF published reports addressing these concerns and indicating that the actual bitcoin market is more regulated and surveilled than expected. This ETF proposal received support from a number of well-known individuals in the industry. In fact, Cole-Frieman & Mallon submitted a comment to the SEC with respect to this ETF proposal in June. Unfortunately, on October 9, 2019, this ETF proposal was rejected as the proposal reportedly did not meet the legal requirements necessary to prevent market manipulation or other fraudulent activities. As another of the entities proposing a bitcoin ETF recently withdrew its proposal from SEC review, there remains only one bitcoin ETF proposal sitting before the SEC. Fund managers interested in the digital asset space should stay apprised of future developments regarding this ETF proposal and others that may follow.

FINRA Approves Membership of Placement Agent for Privately Placed Digital Securities. On August 7, 2019, FINRA approved the membership application of a placement agent for privately placed, digital securities on a permissioned blockchain platform developed by its parent company. It took the placement agent 18 months to get approved, which is longer than what is typically seen, as it had to prove to FINRA that it met regulatory requirements. The approval allows the placement agent to issue securities, provide services as a broker for digital securities, and potentially enter the secondary trading business. This approval stands out as many applications have been waiting to hear back from FINRA for months, and sometimes more than a year. Specifically, this approval will expand investment opportunities for investors and provide fund managers with a streamlined tool to utilize in its investment processes.

SEC Freezes $8 Million in Assets Related to Fraudulent Scheme to Sell Digital Securities to Investors. On August 12, 2019, the SEC froze $8 million in assets raised by an individual and two companies he owns. Allegedly, the parties sold their own token on the internet and induced investors to invest in the token based on material misrepresentations and omissions. The complaint also alleged that the individual manipulated the token price and transferred a significant amount of investor assets to his own personal account. The SEC charged the parties with violating the registration and antifraud provisions of the Federal securities laws and further charged the individual for violating antifraud provisions by manipulating the price of tokens. While this digital asset age has certainly shown promise and innovation, fund managers should be on alert for fraudulent schemes such as this.

SEC Charges Group Operating Unregistered Digital Asset Exchange. On August 29, 2019, the SEC settled charges with a company and its founders who created and sold unregistered tokens to more than 13,000 investors. The founders allegedly falsely claimed each token provided an interest in the company’s cryptocurrency mining facility using below-market rate electricity. In reality, the mining facility did not exist. The company and its founders also allegedly illegally operated an unregistered national security exchange to trade the single token. As new and exciting opportunities in the digital asset space continue to emerge, investors should proceed with caution and should conduct ample due diligence prior to moving forward with such opportunities.

IRS Targets Cryptocurrency Investors with Educational Letter about Back Taxes. In July, the IRS began sending educational letters to taxpayers who have purchased or sold cryptocurrencies but either did not report the income entirely or did not report the income correctly. There are three variations of this letter that more than 10,000 taxpayers will receive, depending on how or if the transactions were reported: Letter 6173, 6174 and 6174-A. In mid-August, the IRS began sending a second round of letters to relevant taxpayers. This notice, which the IRS calls CP2000, is aimed at taxpayers that the IRS has actual records of, showing that there is a discrepancy between the trading profits or losses reported by the taxpayer and what third parties (like exchanges) report to the IRS. The notice includes an amount that each recipient taxpayer is expected to pay in 30 days, with interest. Taxpayers trading cryptocurrency can expect the IRS to ramp up these types of letters and notices and should properly report their transactions to the IRS when filing tax returns to avoid penalties.

SEC Approves First-Ever Reg A+ Token Offering. On July 12, 2019, Blockstack became the first company in history to receive SEC approval for a public securities offering where investors would receive tokens, in this case, called “Stacks”. Blockstack raised a total of $23 million from more than 4,500 investors. $15.5 million was raised through a Reg A+ sale in the United States and the other $7.6 million was raised through a Reg S offering in Asia. Blockstack is working with international exchanges to list Stacks tokens potentially as soon as October 2019. While the full effects of this approval are not yet determined, the SEC’s approval has potential to create a new regulatory roadmap for public token offerings.

FINRA and SEC Issue Joint Statement on Custody of Digital Assets by Broker-Dealers. On July 8, 2019, FINRA and the SEC issued a statement expressing the challenges facing broker-dealer’s custody of digital assets. The statement discussed that a broker-dealer seeking to custody such assets must, like all broker-dealers, comply with the SEC’s Customer Protection Rule. This rule protects customer securities and funds held by broker-dealers by requiring broker-dealers to keep customer assets separate from their firm’s assets, making it more likely that customers’ securities and assets can be returned to them in the case of a broker-dealer’s failure. Many unregistered entities and registered broker-dealers that want to engage in activities involving digital asset securities have been submitting applications to FINRA in the hope that FINRA will allow them to engage in such activities. How these entities could custody digital asset securities while complying with the Customer Protection Rule is still under discussion, but as a start, broker-dealers would need to put in place significant technological enhancements unique to digital asset securities.

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Compliance Calendar.
Please note the following important dates as you plan your regulatory compliance timeline for the coming months:

Deadline Filing
October 10, 2019 Form 13H amendment due if there were changes during Q3
October 15, 2019 Quarterly Form PF due for Large Liquidity Fund Advisers
October 15, 2019 Extended deadline to file Reports of Foreign Bank and Financial Accounts (FBAR)
October 30, 2019 Registered investment advisers must collect access persons’ personal securities transactions
November 1, 2019 Registered investment advisers that seek to withdraw registration with the SEC may begin to submit Form ADV-W‘s, which must be dated 12/31/19
November 11, 2019 Firm may view, print and pay preliminary notice filings (RIA) with all appropriate states
November 14, 2019 Form 13F is due for certain institutional investment managers
November 14, 2019 Form PR filings for registered CTAs that msut file for Q3 within 45 days of the end of Q3 2019
November 29, 2019 Form PF filings for Large Hedge Fund Advisers with December 31 fiscal year-ends filing
November 29, 2019 Large registered CPOs must submit a pool quarterly report (CPO-PQR)
December 16, 2019 Deadline for paying annual IARD charges and state renewal fees
December 31, 2019 Small and mid-sized registered CPOs must submit a pool quarterly report (CPO-PQR)
December 31, 2019 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 2020 CIMA fees
January 1, 2020 California Consumer Privacy Act goes into effect
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

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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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.  Please contact Mr. Mallon directly at 415-868-5345 if you have any questions on this post.