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Author: Cott Law Group

Regulatory Alert: New Reporting Requirements under the Corporate Transparency Act

The Corporate Transparency Act (CTA), enacted as part of the National Defense Authorization Act of 2021, went into effect on January 1, 2024. The CTA is intended to increase corporate transparency and prevent bad actors from using “shell” companies to conduct illegal activities. Under the CTA, domestic and foreign “reporting companies” are required to submit beneficial ownership information (BOI) reports to the U.S. Treasury Department’s Financial Crimes Enforcement Network (FinCEN). The BOI reports are a significant new disclosure requirement for affected companies—please review the information below to determine whether the reporting requirements apply to your company.

What is a reporting company?

A “reporting company” includes (i) domestic corporations, limited liability companies, or other entities formed with a secretary of state or similar office; and (ii) foreign corporations, limited liability companies, or other entities registered to do business in any U.S. state. Notwithstanding the broad definition of a reporting company, there are currently 23 types of entities that are exempted from filing BOI reports.[1] Notably for our clients, the list of exempt entities includes the following: (i) SEC-registered investment advisers (SEC RIA); (ii) venture capital fund advisers that are exempt reporting advisers under Section 203(l) of the Investment Advisers Act of 1940 (Advisers Act); (iii) CFTC-registered commodity pool operator and commodity trading advisors and (iv) pooled investment vehicles (PIVs) operated or advised by an exempt adviser.

Note that state-registered investment advisers, unregistered investment advisers, “private fund advisers” that are exempt reporting advisers under Section 203(m) of the Advisers Act, and PIVs operated or advised by one of the foregoing entities are currently not exempt from the BOI report filing requirements. However, certain affiliates of an exempt entity—e.g., “relying advisers” of an SEC RIA and subsidiaries controlled or wholly owned by an SEC RIA—may also qualify for exemption under specific circumstances.

BOI report disclosure requirements and determining who is a beneficial owner?

BOI reports must include certain information regarding the reporting company and its beneficial owners. A “beneficial owner” is any individual who, directly or indirectly, either (i) exercises substantial control over a reporting company; or (ii) owns or controls at least 25% of the ownership interests of the reporting company. For each beneficial owner, the BOI report must include the individual’s legal name, date of birth, current address and a copy of the individual’s passport or driver’s license.

Whether an individual has “substantial control” of a reporting company depends on the power the individual exercises over the company. For example, an individual is deemed to have substantial control of a reporting company if he or she directs, determines, or has substantial influence over important decisions made by the company. In addition, any senior officer is deemed to have substantial control over a reporting company. The term “senior officer” means any individual holding the position or exercising the authority of a president, chief financial officer, general counsel, chief executive officer, chief operating officer, or any other officer, regardless of official title, who performs a similar function.

Who is a company applicant?

For each entity, there are one or two company applicants: (i) the individual who directly files the document that creates, or first registers, the reporting company; and (ii) the individual who is primarily responsible for directing or controlling the filing of the relevant document (if different). Notably, company applicants formed before January 1, 2024 are not required to disclose their company applicants.

What are the BOI report filing deadlines?

There are three different BOI report filing deadlines, depending on the date a reporting company was created or registered to do business in the U.S.:

  1. Reporting companies created or registered to do business prior to January 1, 2024, must file an initial BOI report by January 1, 2025.
  2. Reporting companies created or registered to do business on or after January 1, 2024, and before January 1, 2025, must file an initial BOI report within 90 calendar days from the date each such company was created or registered to do business.
  3. Reporting companies created or registered to do business on or after January 1, 2025, must file an initial BOI report within 30 calendar days from the date each such company was created or registered to do business.

What are the requirements for updating BOI reports?

Reporting companies must file updated BOI reports within 30 days of (i) any change to the information reported; or (ii) becoming aware that any information reported is inaccurate. For private fund managers, a key change to monitor will be the obligation to file an updated BOI report any time the fund adds a beneficial owner (e.g., each time a limited partner obtains an ownership interest of 25% or more of the fund).

Overall, the CTA represents a significant new reporting requirement for affected companies. We are advising our clients to review the CTA and the BOI report requirements closely to determine whether they must report to FinCEN. As always, feel free to reach out to us should you have any questions.


[1] Full list of exempt entities: securities reporting issuer, governmental authority, bank, credit union, depository institution holding company, money services business, broker or dealer in securities, securities exchange or clearing agency, other Exchange Act registered agency, investment company or investment adviser, venture capital fund adviser, insurance company, state-licensed insurance producer, Commodity Exchange Act registered entity, accounting firms, public utility, financial market utility, pooled investment vehicle, tax-exempt entity, entity assisting a tax-exempt entity, large operating company, subsidiary of certain exempt entities, and inactive entity. Specific criteria apply.

Year-End Client Letter

It has been a choppy year for the investment management industry. High interest rates and recession fears weighed down fundraising and deal activity across asset classes, despite market gains. Meanwhile, the FTX fallout continued to loom large over the crypto community. Nonetheless, we have seen a rebound in new fund launches and increased client activity in general for several months now—if that shift is to be taken as a positive indicator, 2024 may be shaping up to be a busy year.

With that in mind, we would like to highlight the following legal, regulatory and business matters that may affect you or your clients heading into the new year. As always, feel free to reach out to us should you have any questions.

Firm News

Wes Barnes Promoted to Partner. We are thrilled to announce that Wes Barnes has been promoted to Partner. For those of you who have worked closely with Wes over the years, you likely know that (i) the recognition is much deserved; and (ii) he has zero interest in the fanfare of a firm announcement. Please congratulate him anyway.

Legal and Regulatory Changes

Final Rules for Private Fund Advisers. In August, the Securities and Exchange Commission (SEC) adopted new rules (Rules) under the Investment Advisers Act of 1940 applicable to both SEC-registered investment advisers and unregistered advisers. Among other requirements, the Rules require registered private fund advisers to provide investors with quarterly statements and yearly audited financial statements. In addition, the Rules place significant restrictions on the ability of both registered and unregistered private fund advisers to give preferential treatment to certain investors. For more information regarding how the Rules may impact you or your clients going forward, see our regulatory alert from earlier this year.

Corporate Transparency Act. The Corporate Transparency Act (CTA), enacted as part of the National Defense Authorization Act in 2021, requires entities newly formed or registered to do business in the United States (US) on or after January 1, 2024, to submit beneficial ownership reports to the Financial Crimes Enforcement Network (FinCEN). Entities that were formed or registered to do business in the US prior to January 1, 2024, have a one-year grace period to submit their initial reports. Notably, SEC-registered investment advisers and certain venture capital fund advisers—as well as the pooled investment vehicles those entities advise—are exempted from the beneficial ownership reporting requirements. As currently drafted, there is no exemption for state-registered investment advisers.

Digital Assets

Regulation by Enforcement. If 2022 was defined by the FTX fallout, 2023 was defined by US regulators targeting crypto market participants with a flurry of high-profile enforcement actions, culminating with back-to-back lawsuits against Coinbase and Binance in June. During the same month, the CFTC was awarded a default judgment in its lawsuit against Ooki DAO, a decentralized autonomous organization (DAO), highlighting the risk of holding tokens in DAOs that do not include a “liability wrapper”. In July, a potential securities law framework for digital assets began to take shape from contrasting rulings in the SEC’s lawsuits against Ripple Labs and Terraform Labs, respectively. In August, the SEC announced charges against Impact Theory LLC, an issuer of non-fungible tokens (NFTs), in the first enforcement action against an NFT issuer for offering unregistered securities. Most recently, a federal court of appeals overturned the SEC’s decision to reject a spot bitcoin ETF application by Grayscale Investments and ordered the SEC to revisit the application, paving the way for potentially multiple spot bitcoin ETFs to be approved in 2024.

Other than that, not much going on.

Investment Advisers and Exempt Reporting Advisers

Annual Updating Amendment of Form ADV. Each registered investment adviser (RIA) and exempt reporting adviser (ERA) must file an annual updating amendment to its Form ADV. The amendment must be filed within 90 days of the adviser’s fiscal year-end. If you are a client of our firm, be on the lookout for an email from us within the next couple weeks regarding the annual updating amendment process.
 
Each RIA should also provide to each client an updated Form ADV Part 2A brochure and a summary of material changes to the brochure, if any (or simply a summary of material changes, if any, accompanied by an offer to provide the updated brochure).
 
Investment Adviser Registration Depository (IARD) Renewal Fees. Annual renewal fees for SEC and state RIAs, as well as SEC ERAs, were due by December 11, 2023. Notice reminders regarding the fees were sent via email prior to the deadline. Please contact us if you missed the email and/or have not paid the renewal fee.

Unregistered Advisers. Advisers that are neither RIAs nor SEC ERAs must register or, if solely advising private funds, file as an exempt reporting adviser with the SEC upon reaching $25 million in regulatory assets under management (RAUM). If your firm is neither an RIA nor SEC ERA, please contact us prior to exceeding the $25 million threshold to discuss registering as an RIA or filing as an SEC ERA, as appropriate.

Form PF. An investment adviser must file Form PF if it (i) is registered or required to be registered with the SEC; (ii) advises one or more private funds; and (iii) has at least $150 million in private fund assets under management. Note that “private fund assets under management” only includes the portion of an adviser’s RAUM attributable to private funds that it advises. Advisers must file Form PF on an annual basis within 120 days of the fund’s fiscal year-end.

Form CRS. SEC RIAs that advise “retail clients” are required to file and deliver Part 3 of Form ADV (also known as Form CRS) to such clients. Form CRS should be written in plain English and provide retail clients with succinct information about the adviser’s services to retail clients, fees and costs, conflicts of interest, etc. A “retail client” is any natural person who seeks or receives advisory services primarily for personal, family or household purposes. Notably, investment funds are not retail clients (even if underlying investors in the fund are natural persons that would otherwise be retail clients).

Annual Compliance Review. RIAs should review their compliance program annually. The annual review should evaluate, at a minimum, the firm’s Code of Ethics, privacy policy, marketing policies, recordkeeping procedures, the Business Continuity plan, trading restrictions, trading practices, conflicts of interest, ERISA disclosures and compliance violation procedures.

Each RIA must also provide its investors with a copy of its privacy policy on an annual basis, even if no changes have been made to the privacy policy.

Private Investment Funds

Verification of New Issues Status. Fund managers must conduct an annual verification of each account to ensure investors are eligible to participate in initial public offerings or new issues pursuant to FINRA Rules 5130 and 5131. While the initial verification requires affirmative representations by account holders, FINRA allows subsequent verifications to be completed using negative consent letters.
 
Annual Audited Financial Statements. RIAs (and many state ERAs) that manage private funds are generally required to distribute audited financial statements to each fund investor within 120 days of each year-end.

Form D Annual Amendments.  Form D filings for funds maintaining continuous offerings must be amended annually on or before the anniversary of the Form D filing or the filing of the most recent amendment. When amending Form D, the fund should review the entire form and ensure all information is up to date.

Blue Sky Filings.  Fund managers should review their state blue sky filings to ensure they have met any applicable state renewal requirements.

Updating Offering Documents. Private fund managers should review and update fund offering documents each year to address any changes to the investment strategy and fund structure, required risk disclosures, regulatory and tax matters, etc. Please contact us if you need assistance updating your fund offering documents.

Commodity Trading Advisors and Commodity Pool Operators

Annual Reaffirmation of CPO Exemption. Commodity pool operators (CPOs) and commodity trading advisors (CTAs) relying on an exemption from registration with the Commodity Futures Trading Commission (CFTC) are required to reaffirm their exemption eligibility within 60 days of the calendar year-end.

Forms PQR and PR. Registered CPOs and CTAs must file generally CPO Form PQR and CTA Form PR, respectively, using the NFA’s EasyFile system. Registered CPOs must file CPO Form PQR on a quarterly basis within 60 days of each quarter-end. Registered CTAs must file CTA Form PR on a quarterly basis within 45 days of each quarter-end.

CPO Annual Report Updates. Registered CPOs—including CPOs utilizing the CFTC Regulation 4.7 exemption—must distribute an Annual Report to each participant in each pool that they operate, as well as submit a copy of the Annual Report and key financial balances to the National Futures Association (NFA), within 90 days of the pool’s fiscal year-end. An independent certified public accountant must certify the Annual Report.
 
Updating Disclosure Documents. Registered CPOs and CTAs should also check the date of their most recent disclosure documents. Registered CPOs and CTAs are generally prohibited from soliciting clients with a disclosure document that has not been updated within the past 12 months.

If you would like to discuss or require assistance with any of the above items, please do not hesitate to contact Kevin Cott at kevin@cottlawgroup.com. As always, we appreciate your continued business and support. From all of us at Cott Law Group, we wish you a happy and healthy New Year.

Regulatory Alert: SEC Adopts New Rules for Private Fund Advisers

On August 23, 2023, the U.S. Securities and Exchange Commission (“SEC”) adopted new rules under the Investment Advisers Act of 1940 (“Advisers Act”) applicable to both SEC-registered and unregistered private fund advisers (“Rules”). Among other requirements, the Rules require registered private fund advisers to provide investors with quarterly statements and yearly audited financial statements. In addition, the Rules place restrictions on the ability of both registered and unregistered private fund advisers to give preferential treatment to certain investors. Below is a summary of the provisions under the Rules that we consider to be the most noteworthy. 

Quarterly Statement and Audit Requirements

The Rules require registered private fund advisers to present investors with quarterly statements detailing the fund’s performance, fees, expenses and any other compensation paid to the adviser (or its related persons) by the fund or the fund’s portfolio companies. While the current SEC custody rules require registered investment advisers with custody of client assets to provide quarterly account statements to clients, private fund advisers are exempt from this requirement if they distribute annual audited financial statements to fund investors. Although it’s customary for private funds to provide at least quarterly reports to investors, registered private fund advisers should nonetheless confirm that their current reporting procedures comply with the Rules. The SEC will require compliance with the quarterly statement provision within 18 months after the Rules become effective.[1]

Under the current SEC custody rules, registered private fund advisers are generally required to either distribute audited financial statements to investors or be subject to an annual surprise examination. The Rules effectively eliminate the surprise examination option and require all registered advisers of private funds to distribute audited financial statements to investors at the end of each fiscal year.  Despite the available options under the custody rule, private funds typically elect to distribute audited statements to investors; as such, we do not expect the annual audit requirement under the Rules to impact the current practices of most registered private fund advisers. Like the quarterly statement rule, the SEC will require compliance within 18 months after the Rules become effective.

Preferential Treatment

The Rules prohibit both registered and unregistered private fund advisers from providing certain preferential treatment to investors regarding redemption and information rights. Further, the Rules require additional disclosures when funds provide other preferential terms to investors. These provisions will significantly affect an adviser’s ability to enter into side letter agreements with investors.

In the case of redemptions, advisers will no longer be permitted to provide preferential redemption rights to certain investors that the adviser reasonably expects to have a material, negative effect on other investors. As an example, the SEC discussed how allowing an investor to redeem early may leave a fund with fewer liquid assets to use when satisfying future redemption requests for other investors.

The Rules provide for two exceptions to the preferential redemption rights prohibition: (i) redemptions required by applicable laws (i.e., if needed to comply with pay-to-play laws) and (ii) preferential redemption rights afforded to all current and future investors.  For example, a fund is still permitted to have separate share classes with different redemption rights provided that each share class is available to all investors. However, the separate share classes must be available without qualification and not contingent on investment amount, affiliation to the adviser, etc.

Additionally, the Rules prohibit private fund advisers from providing preferential information rights regarding portfolio holdings or exposures to certain investors if the adviser reasonably expects such preferential treatment to have a material, negative effect on the other investors. According to the SEC, selective disclosure of portfolio holdings could allow certain investors to profit or avoid losses at the expense of other investors without access to such additional information. The SEC also pointed to issues in funds with preferential redemption rights where investors could withdraw capital and “front-run” the fund.

Finally, the Rules require private fund advisers to disclose other types of preferential treatment arrangements to current and potential investors. Specifically, advisers must disclose all preferential treatment related to any material economic terms prior to an investor’s investment.  Advisers must also provide investors with annual disclosures of all other preferential treatment arrangements provided to investors since the prior notice. The first notice must be provided (i) for a closed-end fund, as soon as reasonably practicable following the end of the fund’s fundraising period; and (ii) for an open-end fund, as soon as reasonably practicable following the investor’s investment in the fund.

Managers with $1.5 billion or more in private fund assets under management are required to comply with the preferential treatment rule within 12 months of the effective date. All other advisers are required to comply with the rule within 18 months of the effective date. Notably, the preferential treatment prohibitions will not be applied retroactively to governing agreements that were in effect prior to the compliance date and would need to be amended to comply with the Rules. In contrast, no such “legacy status” will be granted with respect to the preferential treatment disclosure requirements under the Rules.

Overall, we believe the preferential treatment portions of the Rules are the headliner. Side letters with preferential terms for certain investors are a longstanding hallmark of operating and investing in private funds—eliminating much of the practice will recalibrate the power dynamics between fund sponsors and certain investors and likely have far-reaching effects upon the entire industry. In the near term, advisers with existing preferential terms in place will need to work with legal counsel to ensure they comply with the new disclosure requirements under the Rules. We will be closely monitoring how the private fund industry adapts to the Rules over the coming months. Please feel free to reach out to us should you have any questions.


[1] The Rules will become effective within 60 days of publication in the federal register.

Ripple and Terraform: A Securities Law Framework for Crypto Begins to Take Shape

There has been a flurry of crypto enforcement news recently, including the Securities and Exchange Commission (“SEC”) suing two major crypto exchanges, Coinbase, Inc. and Binance Holdings Ltd. (“Binance”). The Coinbase and Binance lawsuits represent an existential threat to centralized crypto exchanges that, in part, hinges on whether tokens sold in secondary markets are securities. At the same time, two conflicting rulings last month in the SEC’s ongoing lawsuits against Ripple Labs, Inc. (“Ripple”) and Terraform Labs Pte Ltd. (“Terraform”) provide a possible framework for determining when a digital asset is a security.

Ripple

On July 13, 2023, Judge Analisa Torres of the U.S. District Court for the Southern District of New York (“SDNY”) issued a summary judgment ruling regarding sales of Ripple’s token, XRP. Judge Torres issued a split ruling, finding that direct sales of XRP to institutional investors were a securities offering whereas “programmatic sales” to retail investors on digital asset exchanges were not. Judge Torres’ decision came down to whether XRP qualified as an “investment contract”—a type of security—under federal securities laws. The court, applying a three-pronged test first established by the Supreme Court in SEC v. W.J. Howey Co., defined an investment contract as:

a contract, transaction or scheme whereby a person (i) invests money; (ii) in a common enterprise; and (iii) is led to expect profits solely from the efforts of the promoter or a third party.

Although the court analyzed four types of XRP distributions under the Howey test, the first two are most relevant here: (i) sales of XRP made directly to institutional investors; and (ii) programmatic sales of XRP on digital asset exchanges. Judge Torres found that the initial sale of XRP to institutional investors met all three prongs of the Howey test. Notably, she found that Ripple’s marketing efforts caused the institutional investors to believe that their capital would be used to improve the XRP ecosystem and thereby increase the token’s value. In contrast, Judge Torres found that the programmatic sales of XRP on digital asset exchanges to retail investors failed the third prong of the Howey test because the investors could not have known whether they were purchasing XRP from Ripple.[1]

Huge win for crypto. Hoorah! But wait….

Terraform

Several days later, on July 31, 2023, Judge Jed Rakoff—also from the SDNY—denied Terraform’s motion to dismiss, finding that the SEC adequately pled that sales of Terraform’s UST, LUNA and MIR tokens (collectively, the “Terraform Tokens”) are securities. In determining whether the Terraform Tokens are investment contracts and, in turn, securities, Judge Rakoff applied the Howey test and found that Terraform had “embarked on a public campaign to encourage both retail and institutional investors to buy their crypto-assets by touting the profitability of the crypto-assets and the managerial and technical skills that would allow the defendants to maximize returns on the investors’ coins.”

Judge Rakoff went on to expressly rebuke the Ripple decision:

[t]he Court declines to draw a distinction between these coins based on their manner of sale, such that coins sold directly to institutional investors are considered securities and those sold through secondary market transactions to retail investors are not. In doing so, the Court rejects the approach recently adopted by [Judge Torres].

He added:

Howey makes no such distinction between purchasers. And it makes good sense that it did not. That a purchaser bought the coins directly from the defendants or, instead, in a secondary re-sale transaction has no impact on whether a reasonable individual would objectively view the defendants’ actions and statements as evincing a promise of profits based on their efforts.

A few days later, on August 9, 2023, the SEC announced it will seek an interlocutory appeal of Judge Torres’ decision regarding the programmatic sales of XRP.

Takeaways

Although the SDNY’s decision in Ripple has limited precedential value and the SEC’s appeal was expected, it marked the first significant judicial pushback to the SEC’s perceived “crypto regulation through enforcement” campaign. If Judge Torres’ analysis were adopted as a judicial framework for applying the Howey test to digital assets, the SEC would be hamstrung in enforcement actions against certain token issuers and exchanges. Many commentators were quick to cite the decision as bullish for the prospects of Coinbase and Binance.

However, the Ripple framework never quite made sense, and the Terraform decision throws several gallons of cold water on it. The divergence between the Ripple and Terraform rulings ultimately comes down to Judge Rakoff’s refusal to draw a distinction between direct sales to institutional investors and secondary market sales to retail investors. This seems right—asserting that a reasonable retail investor would not have seen or understood Ripple’s public marketing campaign is dubious. Further, Judge Rakoff’s approach is better aligned with protecting retail investors, a core policy objective of existing securities laws.

Some additional notes:

  • Judge Rakoff agreed with Judge Torres that digital assets are not de facto securities. This is correct. There are myriad examples of cryptocurrencies that are not part of an investment scheme (e.g., certain gaming tokens) or are sufficiently decentralized to not qualify as an investment contract under the Howey test (e.g., BTC).
  • Neither court addressed the crypto elephant in the room: Can a token initially issued as an investment contract become sufficiently decentralized to “evolve” into a utility token? (Or, in the case of ETH, can a token evolve from an investment contract to a sufficiently decentralized utility token and then potentially back to an investment contract with the launch of Ethereum 2.0 and its proof of stake system. Simple stuff.)
  • The inconsistency between these rulings—along with the dizzying logic of the previous note—underscores the need for legislative clarity to fill the regulatory gaps in applying US securities laws to digital assets. Although a recent House bill that would expand the CFTC’s oversight of digital assets has gained traction, it is not expected to clear the Senate.
  • There are legitimate criticisms of the SEC’s public posturing with respect to crypto and its unwillingness to engage with industry participants. However, those are topics for another post. Our analysis here is limited to applying current US securities laws to the sale of tokens as a means for raising capital for development.

In light of the Ripple and Terraform rulings, we see the following framework emerging for sales of digital assets:

  • The Howey test should be applied on a transaction-by-transaction basis, but also: If tokens are initially sold in a manner that constitutes an investment contract—and in a manner in which the tokens have equity-like characteristics—sales on an exchange or other secondary market will continue to qualify as investment contracts (on a transaction-by-transaction basis) unless the token evolves into a utility token. This approach begs the question of when a token originally sold as an investment contract can become sufficiently decentralized to no longer be considered a security, but it still supports the SEC’s position that tokens issued as a means for raising capital for development are generally securities.
  • Put another way: If we think of certain tokens as equity+ (digital assets with equity-like characteristics plus the added use of blockchain functionality), it doesn’t make sense for those tokens to fall outside the scope of US securities laws simply because they contain an additional layer of use. However, it does make sense that “equity+ tokens” could become sufficiently decentralized to evolve into utility tokens. Maybe the next court will tackle the “sufficiently decentralized” question.

We are closely monitoring both cases along with the broader US regulatory environment for digital assets. Please feel free to reach out to us should you have any questions.


[1] While declining to address whether secondary market sales of XRP constitute investment contracts, the court seemed to imply as much by reasoning that the programmatic sales were not investment contracts because the retail investors “stood in the same shoes as a secondary market purchaser who did not know to whom or what it was paying money.”