Overview of the Legal Process to Tokenize a Hedge Fund

By Bart Mallon, with Malhar Oza

As the digital asset industry continues to evolve, we see more use cases for tokenization, including tokenization of private investment funds like hedge, VC and PE funds.  While currently we see more examples of tokenizing various real world assets (RWAs) such as investments in real estate, many groups are now choosing to tokenize private investment funds for a variety of new and innovative reasons.   This blog post is intended to provide information about the legal and operational processes to take into account when tokenizing a private investment fund.

What is being tokenized?

When tokenizing a hedge fund or other private investment fund, we are talking about creating a separate instrument (essentially a digital ledger) on the blockchain in addition to creating all the “real world” formation documents. The total process is more akin to launching an existing private investment fund rather than foregoing the current fund formation and record-keeping process.  In this way we tokenize the RWA of a fund offering – because of this, we first examine the RWA parts of the tokenized fund.

Similarities between Tokenized and Non-Tokenized Funds

While there are many differences between traditional and tokenized funds, from a high level overview, they have essentially equivalent legal/regulatory and operational requirements for the non-tokenized features.  These similarities include: 

Structure – like a traditional fund, a tokenized fund is going to be structured with (1) a management level entity or entities and (2) the fund level entity or entities (including potentially offshore feeder funds).  For any private investment fund, the driving considerations for structure will involve business questions (e.g., where are investors located, where are investments made, etc) and tax (where is the manager physically located, do investors have specific tax needs, etc).  Like traditional funds, managers are going to need to think about how regulatory requirements may affect structure generally (see below for more information here).  For tokenized private investments funds there may also be a token issuing entity as well (discussed below) that will interact with this traditional structure.

Offering Documents – as with a traditional private fund, a tokenized fund needs to have fund offering documents.  Specifically, a tokenized fund will have a PPM, limited partnership (or operating) agreement and subscription documents that will be substantially similar in structure and content to traditional non-tokenized funds.  These documents describe the standard items for any private fund, and also make reference to many of the token-specific characteristics of the investment.

Investment program – while many will assume that a tokenized fund will be a crypto fund, these vehicles can be established to invest in any asset class (traditional securities (publicly or privately traded), real estate, art, commodities, etc.).  The requirement to accurately describe the major aspects of the investment program in the fund offering documents are the same for both tokenized and traditional funds alike. 

Service providers – the main service providers will be the same – this means that the manager will need to engage an administrator, an auditor, a broker/prime broker (if investing in securities on a securities exchange), a digital asset exchange (if trading in digital assets), a custodian, lawyer, etc.  It is important for the manager to work with service providers who are comfortable with the tokenized aspects of the fund.  Sometimes some fund managers will have two sets of attorneys for the fund launch – one set devoted to the standard fund aspects and one set devoted to the tokenized aspects. Where managers engage two sets of counsel, it is paramount each group of attorneys is in sync with the other to ensure proper compliance with securities laws.

Regulation – managers of tokenized funds will need to consider all of the same regulatory items that apply to normal funds.  These items include:

• RIA or CPO/CTA registration – there may be a requirement for the manager to obtain certain licenses based on the fund’s underlying investments or economic activity; for example, RIA registration is required if the manager invests in securities and CPO/CTA registration is required if the fund transacts in futures or commodities.  
• Regulation D – the manager will need to determine whether to utilize Section 506(b) or Section 506(c).  Section 506(c) allows for general solicitation and many tokenized fund managers choose this safe harbor despite there being additional investor qualification requirements.  [Note: some funds may try to tokenize via the Regulation A process, but we don’t think this is optimal.]
• Form D and blue sky filings – as with a normal fund, after fund interests have been sold, the manager will also need to make sure to make Form D and blue sky filings.
• Investment Company Act – the manager will need to choose whether to have the fund use the 3c1 or 3c7 exemptions. 
• Investor qualifications – based potentially on whether the fund will be 3c1 or 3c7, the investors may need to have accredited investor status, qualified client status, or qualified purchaser status.
• Other items to be aware about – AML/KYC (standard in subscription documents, though there should be heightened AML/KYC practices when launching a tokenized product), adequate description of conflicts of interest, whether the fund will be subject to ERISA, making sure marketing materials are accurate, etc.

Token Specific Aspects of a Tokenized Fund

While the many similarities between the two types of funds are clear, there are specific technical items to consider with respect to the tokenized fund.

What blockchain? – perhaps this is going to be the most important technical question for the manager and will influence the characteristics and usefulness of the fund token.  Normally this part is determined by the manager after discussion with their tech team (internal or external) and then relayed to the attorney.  It will be very important for the manager to detail all technical aspects of the generation and potential movement of the fund token to the attorney for appropriate legal analysis. 

When and how are tokens created? – mechanically the fund tokens will need to be generated pursuant to some sort of token creation protocol.  This will depend on other qualities of the fund token including how whitelisting (discussed below) will be done, what blockchain is being utilized, and whether the fund token will interact with certain smart contracts.  

Smart contracts? – depending on the native blockchain and functionality of the fund tokens, managers may choose to allow the fund tokens to interact with certain smart contracts.  The ability for investors to use fund tokens to interact with smart contracts is one of the potential emerging use cases of the fund tokenization process.  Managers should understand what the smart contracts will be doing, and care must be taken such that at all points in the smart contract process all applicable laws and regulations are followed.  The use of whitelisting, among other safeguarding techniques, is a common tool to comply with securities laws among other purposes.  Obviously allowing smartcontract functionality with the fund tokens will increase various technical and legal risks with respect to the fund tokens. 

Transfers and Whitelists – one of the reasons to tokenize private investment fund interests is to allow for easier transfer between token holders through a faster speed of settlement as well as the potential creation of a more robust secondary market.  As these fund tokens represent private fund interests (or only certain features of private fund interests in some cases), any transfers require compliance with all applicable securities regulations and laws.  This means that like in the traditional fund context, the tokenized fund manager will need to continually understand the fund’s investor base (for example: accredited investor, qualified client, qualified purchaser status, number of purchasers/holders, etc,) and may need to be aware of other items as well (holding periods, AML/KYC, etc.) in order to conform to applicable securities laws and regulations.  

Like with traditional funds, the manager ultimately still approves transfers of fund tokens (representing fund interests), even when the transfer is done on the blockchain.  To aid with this, most tokenized funds will need to have some kind of a whitelist of wallet addresses (where the manager knows the identity of the person and/or entity that controls the whitelisted wallet address). This knowledge allows the manager to make sure that any fund token transfers are between parties whom the manager knows and/or are investors in the fund.  Any transfer of the fund tokens needs to abide by securities laws and regulations and the utilization of a whitelist helps the manager ensure compliance.

Offshore lawyers/ jurisdiction – there are two ways that offshore lawyers are important to the tokenized fund launch process.  The first is with respect to normal offshore structuring in the event the fund will have non-US investors.  The second way deals with the jurisdiction of the token itself.  Many times there will be a foundation or other offshore entity that issues the token.  The foundation may or may not be the token issuing entity.  In many cases, the token issuing entity is likely to be an offshore company and offshore counsel is needed in the creation of this entity.

No NY investors in a tokenized fund – it is likely that tokenized funds run afoul of the New York bitlicense requirement.  Unless a manager goes through the process to obtain a bitlicense in New York, the manager will need to make sure that there are no New York resident investors in the fund. Given the potential of each state to implement similar regulations, your choice of counsel should remain up-to-date about all such regulatory regimes.

Tax – on the fund side, these vehicles are taxed like normal private fund vehicles and generally are structured to act as passthroughs for US taxable investors and as “blockers” for non-US investors.  On the investor side, care needs to be taken with respect to any transfers of the fund tokens.  Investors should also talk with tax counsel before using the fund tokens in smart-contracts or other programs because there may be certain tax consequences.  The IRS has been slow to issue guidance, and the asset class is novel and kinetic, so we urge managers to connect with tax counsel throughout the structuring process.

Limitations

Some of the limitations of tokenized fund products stems from uncertain regulatory regimes like the New York Bit License requirement and other states’ similar regulatory regimes. Additionally, the cost and expense of developing the fund token on the blockchain, retaining a tech team, engaging and potentially educating service providers, and the constant regulatory scrutiny of digital assets in general may make fund tokenization unattractive for certain groups. While any private investment fund in any asset class has the potential to become tokenized, groups should internally assess whether tokenization makes sense for the product seeking to be launched.

Specific risks of tokenized funds 

The tokenized fund has both standard risks associated with a private fund, as well risks related solely to the tokenized aspect.  Standard risks include operation of the fund structure, general risks with respect to trading/investment program (including normal liquidity), standard legal and regulatory risks, etc.  In addition to those risks, the following will be applicable to tokenized funds:

• Unclear regulations – investment adviser, IRS, etc
• Risk related to the technology (blockchain generally, DeFi, smart contracts, hacks, private keys, malicious actors, network outages and bugs)
• Token units may have a different “value” than the underlying NAV related to the fund interest, depending on how the manager operates the private fund

Cost and Timing 

Tokenized funds are inherently more resource-intensive to launch given the various structuring components and specialization of the service providers.  Timing for a launch will also be longer than a traditional fund launch to allow for coordination between the lawyers, manager, operations, and technical fund token deployment teams.  A good rule of thumb is that a tokenized fund will probably cost about twice as much in both cost and time than would apply for a non-tokenized fund product.

Issues and Conclusion

Tokenized funds are new vehicles and with any new structure (and unclear regulatory guidance), there are going to be issues that pop up during the launch process.  As discussed above, most issues are likely to be with respect to the mechanical or technical aspects of tokenizing the fund (as opposed to the drafting of the fund offering documents and legal agreements).  We recommend taking more time on the front end to make sure all of the service providers truly understand how the fund token will work during all stages of the token lifecycle – it is vital for the technical functionality of the token is understood and appropriately disclosed in applicable documents.

By some accounts, tokenized funds will become a big part of the future financial world.  If it comes to pass that there is and continues to be a compelling use case for tokenizing a private fund, then we believe that this process will become more and more streamlined.  But, tokenized funds are still novel and relatively untested and complete functionality with respect to a token’s potential will be limited by applicable laws/regulations.  These structures will continue to develop both in standardization in terms of process, cost and timing as more groups seek to tokenized private fund products, and in functionality as more people come to the digital asset space and try to do new and novel things. 

We are very early in this space and are excited for the future.  If you have any questions on how to tokenized a private fund, please contact us or call Bart Mallon directly at 415-868-5345.

****

Bart Mallon, co-founder of Cole-Frieman & Mallon LLP, has established himself as a leader in the private fund space for digital assets and has helped to launch some of the first tokenized private funds.  For more information on his practice please see his bio or reach out to him directly at 415-868-5345.

Malhar Oza works as Counsel at Cole-Frieman & Mallon LLP and assists clients on various operational, transactional and regulatory matters related to digital assets, including fund formation (domestic and offshore). Malhar also counsels crypto managers, investment advisers, digital asset fund managers, and other members of the digital asset investment management industry on complex compliance matters related to state and federal securities laws. He also specializes in launching tokenized fund products, including closed-end and evergreen private investment funds.  To contact Malhar, please email him at [email protected] or give him a call at 415-762-2879.