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Hedge Fund Bits and Pieces for May 26, 2017

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Happy Friday.  Best wishes for a happy and safe Memorial Day weekend!

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Initial Coin Offerings – Bitcoin and other cryptocurrencies took center stage this weeks as new high prices were reached in volatile trading and euphoria around the Consensus Conference earlier this week. Initial coin offerings (or ICOs) were a major topic discussed and should be a major topic going forward.

Artificial Intelligence Hedge Funds – perhaps lost over the last couple of weeks in the discussion of cryptocurrencies has been the general movement in finance toward utilizing artificial intelligence in the investment process. We recently wrote about artificial intelligence hedge fund strategies and detailed the issues that managers should consider when launching a fund in this space.

DOL Rule Effective June 9 – the delay of the DOL rule was short lived.  The DOL recently published a news release announcing that initial implementation of the rule would begin on June 9 (as opposed to April 10, the originally scheduled implementation date) and that “advisers to retirement investors will be treated as fiduciaries and have an obligation to give advice that adheres to “impartial conduct standards” … [t]hese fiduciary standards require advisers to adhere to a best interest standard when making investment recommendations, charge no more than reasonable compensation for their services and refrain from making misleading statements.”

For hedge fund managers, life does not change to a large extent (managers will likely need to update their subscription documents and may need to obtain additional representations from IRA and ERISA investors for any new investment made after June 9, 2017).  SMA managers will need to be careful and should review their relationship with retirement investors.  More information on this will be forthcoming on this blog and in our client updates.

CFTC Focus on FinTech – the CFTC launched a LabCFTC Initiative which “aimed at promoting responsible FinTech innovation to improve the quality, resiliency, and competitiveness of the markets the CFTC oversees.”  The overall goal of the program is to promote innovation for new FinTech products while providing the sponsors of such products more insight into the potential regulatory oversight of those products.  Central to that goal will be GuidePoint which will act as “dedicated point of contact for FinTech innovators to engage with the CFTC, learn about the CFTC’s regulatory framework, and obtain feedback and information on the implementation of innovative technology ideas for the market.”  This sort of proactive approach to innovation by regulators should be a welcome sight to new product sponsors.

Other Items

Cooperman Insider Trading Settlement – Leon Cooperman settled his insider trading case with the SEC, which released an interesting statement on the settlement.  While the settlement allows Cooperman’s fund, Omega, to continue operating, Cooperman and Omega were subject to a $1.7M fine for insider trading.  More importantly, the firm must retain an onsite independent consultant for the next 5 years to guard against insider trading.  There were a couple of additional requirements of the settlement which, with the various fines and independent consultant requirement, have to make the SEC feel like they got a big win here.  It will be interesting to see how or if this settlement is used as precedent in future cases.

SEC Issues Cybersecurity Alert – on the heels of the WannaCry ransomeware attack, the SEC issued a Cybersecurity Alert.   The alert is geared more towards smaller broker-dealers and investment advisory firms and provides background and links to other SEC resources on this issue.

New York Employers Cannot Ask About Salary History – on May 4, New York Mayor de Blasio signed a bill making it illegal (and subject to fines) for an employer to ask questions about a candidate’s prior compensation.  Hedge fund managers located in New York will want to discuss this issue with their internal HR persons, as well as their outside counsel.  The bill is called “Intro. 1253” and  goes into effect 180 days after the signing. A cached version of the de Blasio press release can be found here.

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

Initial Coin Offerings (ICOs)

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ICO Overview and Securities Law Analysis

After a number of recent, high-profile and wildly successful Initial Coin Offerings or “ICOs”, the blockchain-based asset industry has been abuzz about new ICOs as well as the regulatory issues that surround the space.  This post provides a quick overview of the big securities laws issues surrounding these assets and discusses the regulatory structure currently applicable to the space.

Initial Background

An initial coin offering is the first distribution of a digital currency or digital token, normally offered exclusively through an online offering.  These coins or tokens, like many existing cryptocurrencies such as Bitcoin or Ether, may represent some sort of fractional ownership in something (working similar to a security) or may represent a form of payment (like a currency).  These tokens may be pre-launch (to raise money to develop the use case, similar to crowd-funding) or post-launch (use case already exists).

Are ICOs Securities?

The first and biggest question related to ICOs is whether they are securities offerings (essentially digitized IPOs).  For any inquiry into whether something is a security or not, the starting point is the Howey Test.  Howey is a basic four-part test that is used to determine whether a contract, a transaction, or a series of actions constitutes a security under the Securities Act of 1933. The very broad overview of the Howey prongs are:

  • It is an investment of money
  • There is an expectation of profits from the investment
  • The investment of money is in a common enterprise
  • Any profit comes from the efforts of a promoter or third party

For many ICOs the answers to all of the above are usually “yes”.  We do, however, believe that some ICOs are not securities under the test and, although we start with Howey, that is not where the analysis stops.  As mentioned before in our post dealing with Bitcoin Hedge Funds, we believe that Debevoise’s Securities Law Framework provides a thoughtful approach to think about and analyze this question.  We also believe that the SEC will clarify its position regarding ICOs in the next several months.

Use Case – Blockchain Capital

One of the more interesting ICOs recently has been the ICO for the Blockchain Capital Token (BCAP Token, on TokenHub), which was placed by Argon Group, a blockchain asset investment bank.  Here the value of the BCAP Token is linked to the value of a newly created venture capital fund (which initial assets were received through the BCAP Token ICO process).  The subscription process of the ICO was conducted through a Regulation D 506(a) offering (see Blockchain Capital Token Form D), so there are a number of regulations that the group has already gone through, although none specifically dealing with the ICO itself.  What is particularly amazing is that the offering of $10M was oversubscribed and closed in only 6 hours.  The power of the ICO is apparent – what investment fund manager would not want to raise money in a very quick and efficient manner?

Blockchain Capital paved the way for ICOs linked to private investment funds – we would expect to see tokens linked to hedge funds and private equity funds in the near future.  While the Blockchain Capital offering was limited to accredited investors, the offering still presents questions about regulations, including the potential for fraud.  We liken the ICO process to something akin to the crowdfunding process and believe there are similar risks, in addition to the normal risks associated with the linked asset (in this case, a VC fund).

Future Regulation?

There is no doubt that the regulators will begin to figure out a regulatory regime for ICOs and cryptocurrencies, and this is likely to happen before any sort of Congressional action to change the laws of any of the securities or commodities acts.  The CFTC has already been active in the space (see our previous notes in our Client Update here) and it is very likely that the SEC will be starting the process to issue regulations as well (see here where a group has petitioned the SEC to begin that process).  We believe that during that comment and rulemaking process, the regulators will need to address a number of items, including the process with respect to ICOs.  The SEC needs to move with a deft hand, however, because any onerous regulations will just push business offshore – there are already exchanges who discriminate against potential market participants based on domicile (either with respect to U.S. domicile, or in some cases, New York domicile for fear of issues around the New York BitLicense regulations).

The crowdfunding space became regulated fairly quickly and there are now specific crowdfunding broker-dealers and I believe the same will be the case with the ICO regime.  We believe that any cryptocurrency regulatory regime will include requirements with respect to ICOs and ICO investment banks.

Conclusion

The ICO market is white hot and getting hotter.  It will undoubtedly create both winners and losers (and the winners are likely to be massive winners) and in some cases will usher in new ideas and technologies that will help define the landscape of Web 3.0.  The most important thing for regulators (and lawmakers) is to make sure all investors in these offerings are protected and provided with all necessary information and opportunities as provided through the current securities and commodities laws.  We believe that such regulation will come sooner rather than later.

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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.