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

Written by Cott Law Group on . Posted in Digital Assets & Cryptocurrency Funds, Regulatory & Compliance. No Comments on 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.”

Client Alert—Coinbase and Binance Lawsuits

Written by Kevin Cott on . Posted in Digital Assets & Cryptocurrency Funds, Regulatory & Compliance.

On June 6, 2023, the U.S. Securities and Exchange Commission (“SEC”) brought a five-count civil complaint in New York federal court against Coinbase Inc. (“Coinbase”). The complaint alleges that Coinbase operates as an unregistered broker, exchange and clearing agency. The SEC asserts that Coinbase’s failure to register “deprive[s] investors of significant protections, including inspection by the SEC, recordkeeping requirements, and safeguards against conflicts of interest, among others.”

According to the SEC’s complaint, Coinbase lists at least 13 “crypto asset securities”[1] on its platform and offers a “staking-as-a-service” product. Earlier this year, the SEC charged Kraken with failing to register its staking-as-a-service product; Kraken settled the case and shut down its staking investment program in the United States.

The complaint against Coinbase came one day after the SEC brought action against Binance Holdings Ltd. and its affiliates (“Binance”) for also operating as an unregistered broker, exchange and clearing agency. In addition, the SEC charged Binance with failing to restrict U.S. investors from accessing Binance.com and misleading investors concerning the existence of market surveillance and controls to prevent manipulative trading on an affiliated Binance website. The SEC also charged Binance’s founder and chief executive, Changpeng Zhao, with deliberately and secretly trying to evade US laws.

While the respective lawsuits against Coinbase and Binance largely overlap in terms of legal issues, the complaint against Coinbase notably lacks the allegations of fraud and mismanagement found throughout the Binance complaint. That may be one silver lining; a pivotal lawsuit involving the largest US-based crypto exchange—without the distraction of fraud charges—may provide the best opportunity to date for clear guidance regarding the application of existing US securities laws to crypto assets.

These cases also serve as a backdrop for any potential legislative action. Near-term legislative action appears unlikely, however, despite House members releasing a crypto regulation discussion draft last week. For now, the SEC appears to be intent on regulating crypto assets it deems securities through enforcement. We advise all industry participants to monitor these cases closely and proceed accordingly. For crypto fund managers and investors, we recommend identifying any potential liquidity risks resulting from exposure to targeted exchanges or tokens deemed to be unregistered securities by the SEC.

As always, please feel free to reach out to us if you have any questions.

[1] The Coinbase complaint lists 13 cryptocurrencies as securities: SOL, ADA, MATIC, FIL, SAND, AXS, CHZ, FLOW, ICP, NEAR, VGX, DASH and NEXO.

Client Alert—Silicon Valley Bank

Written by Kevin Cott on . Posted in Digital Assets & Cryptocurrency Funds.

Last Friday, Silicon Valley Bank (SVB) was abruptly closed and designated for receivership with the Federal Deposit Insurance Corporation (FDIC). The closure of the bank is notable because SVB had over $200 billion in deposits and was the financial institution of choice for startups, fintechs and their venture capital / private equity partners, many of whom held deposits in excess of the FDIC-insured limit of $250,000.

By Sunday evening, Signature Bank (Signature), a New York state-chartered bank with diverse business lines—including commercial real estate and cryptocurrency banking— was also shuttered, prompting the Department of Treasury, the Federal Reserve and the FDIC to announce emergency measures to prevent losses to all depositors and provide liquidity support to banks.

By Monday afternoon, the FDIC further announced that all bank deposits at SVB—both insured and uninsured—had been transferred to a new FDIC-operated “bridge bank” called Silicon Valley Bank, N.A (SVB N.A.). This fully operational national bank will operate in the interim until the FDIC can secure a buyer for SVB. The establishment of SVB N.A. means that all deposits at SVB N.A. are now fully accessible and that all bank deposits will be fully protected. Nonetheless, the FDIC reiterated that shareholders and certain unsecured debt holders will not be protected. Those with exposure to SVB can verify their insurance status through the FDIC’s claims portal.

Zooming out, the banking landscape for digital asset funds and managers in the US remains in flux, and the sudden collapse of SVB and Signature underscores the importance of fund managers actively monitoring their banking relationships and market developments to ensure they are taking appropriate measures to safeguard client assets. As an example, fund managers should evaluate whether it is in their clients’ best interests to bank with multiple partners to limit individual bank exposure or, at a minimum, have a secondary banking partner.

We are committed to assisting our clients with navigating the current landscape and have already reached out to our network of banking partners, including those that continue to work with digital asset funds and managers. Please feel free to reach out to us should you have any questions.

 

 

SEC Proposes Amendments to Custody Rule and Targets Digital Assets

Written by Kevin Cott on . Posted in Digital Assets & Cryptocurrency Funds, Regulatory & Compliance.

On February 15, 2023, the SEC released Rule 223-1 (the “Safeguarding Rule”) under the Investment Advisers Act of 1940 (the “Advisers Act”), proposing amendments to Advisers Act Rule 206(4)-2 (the “Custody Rule”). The Safeguarding Rule would greatly broaden the reach of the Custody Rule and captures a wide range of assets, including digital assets, real estate, loans, and other emerging asset classes, in addition to physical assets. Should the proposal be adopted in its current form, it will significantly impact how registered investment advisers manage and protect their clients’ assets.

Below is a brief overview of some of the more notable changes under the Safeguarding Rule.

      I. Minimum Custodial Protections

The Safeguarding Rule, among other things, outlines minimum custodial protections which would require an adviser to enter into a written agreement with qualified custodians to provide fundamental protections. The proposed requirements are “designed to serve as guardrails” and do not prescribe specific procedures. Some changes include:

  • the Custody Rule would be expanded to apply to all client assets held in advisory accounts, not just client “funds and securities,” explicitly including digital assets;
  • advisers with custody of client assets would be required to maintain them with a qualified custodian. The qualified custodian must have “possession or control” of client assets and participate in any change of beneficial ownership of the client’s assets;
  • a qualified custodian should indemnify an advisory client when its negligence, recklessness or willful misconduct results in that client’s loss;
  • a qualified custodian should clearly identify an advisory client’s assets and segregate them from the custodian’s proprietary assets;
  • the client’s assets should remain free of liens in favor of a qualified custodian unless authorized in writing by the client;
  • the exception for “privately offered securities” would be rescinded in favor of a new exception from the requirement to maintain certain assets with a qualified custodian, provided that the adviser meets certain conditions; and
  • a custodial agreement would need to reflect an adviser’s agreed-upon level of authority to effect transactions in the advisory client’s account.

      II. Qualified Custodian

There are not material changes to what types of entities could serve as qualified custodians, though there are additional compliance requirements. Banks or savings associations (including trust companies); registered broker-dealers; registered futures commission merchants; and certain types of foreign financial institutions may serve as qualified custodians. Foreign financial institutions would need to meet additional qualification requirements not currently part of Rule 206(4)-2. In addition, the Safeguarding Rule would require that a qualifying bank or savings association hold client assets in an account that is designed to protect the assets from creditors or in the event of insolvency. Specifically, the qualifying bank or savings institution must maintain the client’s assets in an account in which assets are easily identifiable and clearly segregated from the bank’s assets. The Safeguarding Rule also expands the criteria specifically required of foreign financial institutions that seek to qualify as custodians.

      III. Digital Asset Implications

The Safeguarding Rule extensively addresses digital assets. Some significant implications for advisers that deal with digital assets:

  • Digital assets are in scope. In the Safeguarding Rule, the SEC asserts that the present Custody Rule covers digital assets. The SEC does not elaborate or analyze why digital assets are considered “funds,” as opposed to other types of property.
  • Possession or control. The requirement for qualified custodians to have “possession or control” of client assets may pose challenges for custodians of digital assets. It’s difficult to prove exclusive possession or control of digital assets due to their unique characteristics. However, the Safeguarding Rule allows for flexibility in demonstrating “possession or control” by permitting situations where the custodian is necessary to change the ownership of the asset. For instance, a “qualified custodian would have possession or control of a digital asset if it generates and maintains private keys for the wallets holding advisory client digital assets in a manner such that the adviser is unable to change beneficial ownership of the digital asset without the custodian’s involvement.”
  • Digital asset trading platforms. The SEC acknowledges that the requirement for qualified custodians to have “possession or control” of client assets while the investment adviser has custody presents a challenge for advisers trading on digital asset platforms that require prefunding. If the trading platform is not a qualified custodian, it would violate both the current Custody Rule and the Safeguarding Rule. However, the SEC points out that not all digital asset trading involves prefunding, and some trades occur on noncustodial decentralized platforms and Alternative Trading Systems (“ATSs”).

      IV. Form ADV amendments.

The Safeguarding Rule includes updates to recordkeeping requirements for advisers and changes to Form ADV regarding custody-related data that the Commission, its staff and the public can access. The proposed changes to Item 9 reporting requirements include more information on the basis of custody of client assets, qualified custodians responsible for maintaining client assets and independent public accountants engaged for surprise examinations or financial statement audits of private funds.

      V. Compliance transition.

Under the Safeguarding Rule, advisers with over $1 billion in regulatory assets under management (“RAUM”) would be required to comply with the rule within one year of the rule’s effective date, while advisers with less than $1 billion in RAUM would have 18 months to comply the rule.

The comment period will be open for 60 days following publication of the proposing release in the Federal Register.

Key Takeaways:

  • The SEC proposed the Safeguarding Rule, which expands the Custody Rule under the Advisers Act to include all client assets, including digital assets.
  • Advisers with custody of client assets would be required to maintain them with a qualified custodian who indemnifies clients in case of loss, clearly identifies and segregates client assets from proprietary assets, and maintains them in a separate account designed to protect them from creditors or insolvency.
  • Banks, broker-dealers, futures commission merchants, and certain foreign financial institutions may serve as qualified custodians, but they must comply with additional qualification requirements and criteria. Custodians may have to segregate digital assets into dedicated accounts to ensure their safekeeping, preventing the mixing of assets with the adviser’s or related parties’ assets.
  • The Safeguarding Rule extensively addresses digital assets and acknowledges that they are in scope. The requirement for custodians to have “possession or control” of digital assets may pose challenges for custodians, but the rule allows flexibility in demonstrating “possession or control” and includes provisions for digital asset trading platforms.
  • The Safeguarding Rule includes updates to recordkeeping requirements for advisers and changes to Form ADV regarding custody-related data that the Commission, its staff and the public can access.
  • Advisers with over $1 billion in AUM would have to comply with the new rule within one year of its adoption, while smaller advisers would have 18 months to comply.

Section 1061 Updates to Partnership Agreements

Written by Kevin Cott on . Posted in Digital Assets & Cryptocurrency Funds, Hedge Funds, Venture Capital, Private Equity & Real Estate Funds.

In anticipation of the March 15, 2023, filing deadline for partnership tax returns, we recommend that clients assess whether their fund partnership agreements are current regarding the implications of Section 1061 of the Internal Revenue Code (Section 1061). Section 1061 largely took effect on January 1, 2022, and was introduced as part of the 2017 Tax Cuts and Jobs Act in an effort to limit the favorable tax treatment afforded to some recipients of performance allocations or carried interest.

Under Section 1061, the holding period for certain applicable partnership interests (APIs) acquired in connection with the performance of substantial services was extended from one year to three years. This generally means that if a fund’s general partner holds an API for less than three years—or the API relates to an asset that has been held for less than three years—any resulting capital gains may be subject to recharacterization as short-term capital gains. Notably, however, the three-year extended holding period does not apply to capital gains and losses allocated to a holder of a capital interest when the right to share in profits is commensurate with the holder’s capital contributions (Capital Interest). In other words, Section 1061 generally does not apply to a general partner’s capital contributions and reinvested gains.

As a result, we recommend that fund general partners confirm their fund partnership agreements create separate accounts for tracking Capital Interests and performance allocations or carried interest. Additionally, fund general partners should confirm with their fund administrators that separate accounts for Capital Interests and performance allocations or carried interest are being maintained in the fund’s books and records. Absent such separate tracking, fund general partners run the risk of Section 1061 applying to their entire capital account regardless of the source of gains and losses. Please note that any such updates to fund partnership agreements should be made prior to March 15, 2023.

We encourage you to reach out to us if you would like for us to review your fund partnership agreement to assess whether it needs to be amended to address Section 1061. If you would like our assistance, feel free to reach out directly to Kevin Cott at kevin@cottlawgroup.com.

Year-End Client Letter

Written by Kevin Cott on . Posted in Digital Assets & Cryptocurrency Funds, Hedge Funds, Regulatory & Compliance, Venture Capital, Private Equity & Real Estate Funds.

As we turn the page on 2022, 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.

Investment Advisers and Exempt Reporting AdvisersAnnual Amendment of Form ADV. Each registered investment adviser (RIA) and exempt reporting adviser (ERA) must file an annual updated amendment to its Form ADV. The annual amendment must be filed within 90 days of the adviser’s fiscal year-end.

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 Securities and Exchange Commission (SEC) and state RIAs, as well as SEC ERAs, are due to the IARD by December 12, 2022.  Please visit www.iard.com for more information.

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. Investment advisers must file Form PF on an annual basis within 120 days of the fund’s fiscal year-end.

Form 13H Amendments. All large traders that have made a Form 13H filing with the SEC are required to submit an annual filing within 45 days of the end of each calendar year.

SEC Matters

New SEC Investment Adviser Marketing Rules are Now in Full Effect. The SEC’s new marketing rules took effect on November 4, 2022. As of that date, RIAs are no longer permitted to choose to comply with the previous advertising and cash solicitation rules.

Broadly, the new marketing rules include updates to (i) the definition of an advertisement; (ii) generally prohibited advertising practices; (iii) the parameters for including testimonials, endorsements and third-party ratings; and (iv) the parameters for including performance results. The SEC also amended the books and records rules to require investment advisers to maintain records of certain advertisements, as well as amended Form ADV to require advisers to disclose their marketing practices.

On September 19, 2022, the SEC released guidance regarding how examinations will focus on the new marketing rules. Specific areas of review will include whether advisers have (i) adopted and implemented written policies and procedures designed to prevent violations of the new rules; (ii) a reasonable basis for believing they can substantiate material statements of fact in advertisements; (iii) complied with the new rules regarding performance advertising; and (iv) followed the amendments to the books and records requirements and accurately completed the new portion of Form ADV relating to the marketing rules.

The new portion of Form ADV was added to Item 5 of Part 1A.

SEC Proposes Significant Changes in Private Fund Regulation. On February 9, 2022, the SEC proposed new rules and regulations under the Investment Advisers Act of 1940 applicable to both SEC-registered and unregistered private fund advisers. The intent of the proposed rules is to require fund managers “to provide transparency to their investors regarding the full cost of investing in private funds and the performance of such private funds.”

See our full blog post with a summary of the proposed rules here. Generally, the proposed rules require annual audits and quarterly statements for RIAs (in lieu of the surprise examination option) and prohibit certain activities for SEC-registered and unregistered private fund advisers. Notably, one of the proposed prohibited practices involves the use of side letters that provide select fund investors with favorable terms. Under the proposed rules, these side letters would need to be disclosed to all prospective and current investors. The initial comment period for the proposed rules was set to end on April 25, 2022. The SEC later extended the comment period to June 13, 2022.

SEC Proposes Amendments to Form PF. On August 10, 2022 the SEC proposed amendments to Form PF in an effort to bolster the Financial Stability Oversight Council’s ability to assess systemic risk along with the SEC’s regulatory authority over fund managers and its investor protection efforts. Generally, the proposed amendments seek to (i) enhance reporting by large hedge fund advisers on qualifying hedge funds; (ii) enhance reporting on basic information about advisers and the private funds they advise; (iii) enhance reporting concerning hedge funds; (iv) amend how advisers report complex structures; and (v) remove aggregate reporting for large hedge fund advisers.

Notable to the digital asset space, the proposed amendments add a new sub-asset class for digital assets and include a definition for the term “digital asset.” The SEC specifically requested comments with respect to how digital assets should be categorized and disclosed. The comment period ended on October 11, 2022.

SEC Charges Advisory Firms for Custody Rule and ADV Violations. On September 9, 2022, the SEC issued a press release detailing charges against multiple investment advisers for failing to comply with SEC custody rules and/or failing to update the status of their audited financial statements on Form ADV. The firms ultimately agreed to pay civil penalties totaling more than $1 million. In detailing the charges, the SEC re-emphasized that RIAs managing private funds should ensure they are distributing audited financial statements to investors in a timely manner and updating their Form ADVs when audited financial statements are received. Specifically, the SEC noted that if an RIA checks “Report Not Yet Received” under Part 1A, Schedule D, Section 7.B.23 of its Form ADV, it must promptly file an amendment when the report is available. ERAs should also keep this in mind to the extent their funds are subject to an annual audit.

The charges follow an SEC settlement with another registered adviser in March for failing to maintain adequate policies and procedures regarding the custody rule and failing to deliver audited statements in a timely manner. RIAs managing private funds should review their policies and procedures to confirm they are currently compliant.

SEC Proposes New Requirements for Outsourced Services. On October 26, 2022, the SEC proposed new rules for RIAs that prohibit outsourcing certain functions without appropriate due diligence and monitoring of the service providers. The proposed rules apply to “covered functions,” which are functions or services that (i) are “necessary to provide advisory services in compliance with the Federal securities laws”; and (ii) “if not performed or performed negligently, would be reasonably likely to cause a material negative impact on the adviser’s clients or on the adviser’s ability to provide investment advisory services.” The proposed rules outline the due diligence procedures required before retaining a service provider to perform a “covered function” and require advisers to obtain reasonable assurances that third-party recordkeepers meet certain enumerated standards regarding their recordkeeping procedures. The SEC is currently accepting comments regarding the proposed rules until December 27, 2022.

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 CPO-PQR and CTA-PR. Registered CPOs and CTAs must file Form CPO-PQR and Form CTA-PR, respectively, using the NFA’s EasyFile system. Registered CPOs must file Form CPO-PQR on a quarterly basis within 60 days of the quarters ending in March, June and September, as well as within 90 days of the calendar year-end. Registered CTAs must file Form CTA-PR on a quarterly basis within 45 days of each quarter-end.

Advisers that are dually registered with the SEC and the CFTC may satisfy certain Form CPO-PQR filing requirements by filing Form PF by the Form CPO-PQR deadline.

CPO and CTA 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.

CPOs should also check the date of the most recent disclosure document of each pool they operate. CPOs are generally prohibited from soliciting clients with a disclosure document that has not been updated within the past 12 months.

CFTC and NFA Matters

CFTC Releases Enforcement Results for 2022. On October 20, 2022, the CFTC released its annual enforcement results for the fiscal year 2022. In total, the CFTC obtained orders imposing over $2.5 billion in payments and filed 82 enforcement actions. Notably, 18 of the CFTC actions involved digital assets. The digital asset-related actions largely involved either unregistered exchange activity or untrue/misleading statements made in connection with digital assets. The CFTC has general authority over most digital asset derivative transactions and has broad anti-fraud authority over spot digital asset transactions. The CFTC’s Division of Enforcement has a task force specifically dedicated to digital assets, and we expect to see the CFTC continue to prioritize bringing regulatory actions in the digital assets space.

CFTC Finds DAO Liable as an Unincorporated Association. On September 22, 2022, the CFTC filed an enforcement action in the U.S. District Court for the Northern District of California charging a decentralized autonomous organization (DAO) with illegally offering retail commodity transactions in digital assets. The CFTC alleged the DAO solicited customers for its software protocol that allowed users “to open leveraged positions whose ultimate value was determined by the price difference between two digital assets from the time the position was established to the time it was closed.” The CFTC classified these transactions as retail commodity transactions that were unlawful since they did not take place on a designated contract market.

The founders of the protocol transferred the protocol from a limited liability company to the DAO and then touted the DAO’s ability to avoid regulation. However, the CFTC stated that the DAO and its members should nevertheless be liable based on the existence of the DAO as an unincorporated association. The CFTC also filed an enforcement action against the original LLC and its founders. Significantly, the enforcement action and order demonstrate the CFTC’s willingness to go after DAOs and their participants. Fund managers should keep this regulatory risk in mind when investing in decentralized finance (DeFi) projects involving DAOs.

Digital Assets Matters

FTX Fallout. On November 11, 2022, FTX Trading Ltd. and its affiliates (FTX) filed for Chapter 11 bankruptcy protection in Delaware. The bankruptcy sent shockwaves through the crypto industry not seen since the Mt. Gox collapse in 2014. We are actively working with our clients impacted by FTX’s collapse to develop appropriate responses, from both a legal and a business operations standpoint. Although the collapse is a repeat of financial fraud as old as time rather than an indictment of blockchain technology and decentralization (it is arguably the opposite), it does shine a light on the need for clearer regulation. We continue to expect the SEC to emerge as the leading regulator of crypto exchanges and tokens and are monitoring potential legislative responses from Congress. Although there appears to be bipartisan support for certain reforms such as separating custody from trading platforms, unique challenges remain such as how to prevent non-US exchanges that may fall outside the US regulatory regime from interacting with US customers.

SEC Scales Up Crypto Enforcement Team. On May 3, 2022, the SEC announced it was nearly doubling its Crypto Assets and Cyber Unit in its Division of Enforcement from 30 to 50 dedicated positions. The expanded Crypto Assets and Cyber Unit is tasked with focusing on securities law violations related to crypto asset offerings, exchanges and lending products, as well as DeFi platforms, non-fungible tokens (NFTs) and stablecoins. The expansion of the SEC’s crypto enforcement arm is consistent with SEC Chair Gary Gensler’s sustained push to establish the SEC as crypto’s chief regulator of the asset class.

DOJ Charges Former OpenSea Employee in First Digital Asset Insider Trading Scheme. On June 1, 2022, the US Attorney’s Office for the Southern District of New York and the Federal Bureau of Investigation announced charges against a former product manager at OpenSea, the world’s largest NFT marketplace, for a scheme to commit insider trading. The OpenSea employee allegedly used confidential information regarding which NFTs were going to be featured on OpenSea’s homepage to invest ahead of the announcements. Interestingly, the DOJ elected to sidestep the issue of whether the underlying NFTs were securities by charging the defendant with wire fraud and money laundering.

SEC Charges Former Coinbase Manager with Insider Trading. On July 21, 2022, the SEC announced insider trading charges against a former Coinbase product manager and others for trading ahead of multiple announcements regarding tokens that were being added to the Coinbase trading platform. The SEC appeared to use the charges to regulate through enforcement by explicitly noting that many of the underlying tokens are securities. While the SEC has previously identified tokens as securities, those charges typically involved direct enforcement actions against an issuer. As SEC Division of Enforcement Director Gurbir Grewal noted, the case highlights the SEC’s focus on treating many tokens as securities regardless of label.

SEC Charges Influencer for Touting Token. On October 3, 2022, the SEC announced charges against Kim Kardashian for touting EthereumMax tokens on her Instagram account without disclosing that she was paid $250,000 to publish the post. Ms. Kardashian agreed to settle the charges, cooperate with the SEC’s ongoing investigation and pay $1.26 million in penalties, disgorgement and interest. In addition to reinforcing the SEC’s position that many tokens are securities offerings subject to federal securities laws, the charges and settlement were a highly publicized warning to celebrities and influencers to avoid promoting tokens on their social media accounts without disclosing compensation received from the token issuer.

Additional Compliance Matters

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 that manage private funds are generally required to distribute audited financial statements to each fund investor within 120 days of each year-end.

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.

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.

If you 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.

Proposed Rule Changes for Private Fund Advisers

Written by Kevin Cott on . Posted in Digital Assets & Cryptocurrency Funds, Hedge Funds, Regulatory & Compliance, Venture Capital, Private Equity & Real Estate Funds.

On February 9, 2022, the Securities and Exchange Commission (SEC) proposed new rules (Proposed Rules) under the Investment Advisers Act of 1940 (Advisers Act) that, if adopted, would significantly impact private fund advisers. Below is a high-level summary of the Proposed Rules and their potential impact on affected advisers.

Annual Audit Requirement

The Proposed Rules would require SEC-registered advisers to obtain annual audited financial statements for each private fund they advise. Fund auditors would also be required to promptly notify the SEC if a modified opinion is issued or the auditor’s engagement is terminated.

Notably, the audit requirement under the Proposed Rules is a separate and distinct requirement from custody requirements pursuant to Rule 206(4)-2 under the Advisers Act, i.e. the Proposed Rules do not permit advisers to elect a surprise examination in lieu of an audit.

Quarterly Statements

Under the Proposed Rules, SEC-registered advisers would be required to provide quarterly account statements to investors in each private fund they advise. The statements would need to be presented in a standardized format that includes a “detailed accounting” of specific fee and expense disclosures, portfolio investment compensation paid to the adviser or its affiliates, standardized fund performance information based on the type of fund (i.e. “liquid” vs. “illiquid”), etc. The statements would need to be provided within 45 days of the end of each calendar quarter.

Prohibited Activities

The Proposed Rules would prohibit both SEC-registered and unregistered advisers from certain activities with respect to private funds, including the following:

  • Providing preferential treatment to certain investors via side letter agreements (Side Letters) with respect to redemption rights or access to information regarding portfolio holdings or exposures, if the adviser reasonably expects such preferential treatment would have a material, negative effect on other investors (although not outright prohibited, certain other preferential terms—including fee discounts and additional investment rights—would need to be disclosed in writing to prospective and current investors);
  • Reducing clawbacks of carried interest paid to the adviser to be net of taxes;
  • Reimbursing, indemnifying or limiting the liability of the adviser for breaches of fiduciary duties, willful misfeasance, bad faith, recklessness or negligence in providing services to a private fund;
  • Charging private funds for accelerated monitoring fees, costs related to examinations or investigations of the advisers or adviser regulatory and compliance costs;
  • Borrowing funds from a private fund; and
  • Allocating costs related to portfolio investments held by multiple funds and/or co-investment vehicles on a non-pro rata basis.

With respect to the prohibited activities in connection with Side Letters, the lack of a “grandfathering” provision would be uniquely challenging for existing advisers affected by the Proposed Rules; such advisers would effectively have to choose between complying with the Proposed Rules or breaching a previously granted Side Letter provision.

A public comment period regarding the Proposed Rules will remain open for 60 days following publication on the SEC website or 30 days following publication in the Federal Register, whichever is longer. The Proposed Rules would mark a landmark shift in SEC regulation of private fund advisers, and we will continue to monitor any related developments. Should you have any questions regarding this alert or the Proposed Rules in general, feel free to contact Kevin Cott at kevin@cottlawgroup.com.

Year-End Client Letter

Written by Kevin Cott on . Posted in Digital Assets & Cryptocurrency Funds, Hedge Funds, Regulatory & Compliance, Venture Capital, Private Equity & Real Estate Funds.

As we turn the page on 2021, 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.

Investment Advisers and Exempt Reporting Advisers

Annual Amendment of Form ADV. Each registered investment adviser (RIA) and exempt reporting adviser (ERA) must file an annual updated amendment to its Form ADV. The annual amendment must be filed within 90 days of the adviser’s fiscal year-end.

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 Securities and Exchange Commission (SEC) and state RIAs, as well as SEC ERAs, were due to the IARD by December 13, 2021.  Please visit www.iard.com for more information.

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. Investment advisers must file Form PF on an annual basis within 120 days of the fund’s fiscal year-end.

Form 13H Amendments. All large traders who have made a Form 13H filing with the SEC are required to submit an annual filing within 45 days of the end of each calendar year.

New Rules for New York Investment Adviser Representatives. Prior to February 1, 2021, New York did not require investment adviser representatives, principals, supervisors or solicitors (IARs) to register with the state. Effective as of February 1, 2021, IARs representing a New York RIA or SEC RIA with a New York place of business are required to register. Absent a waiver, IARs must either pass the Series 65 exam or a combination of the Series 7 and Series 66 exams within 2 years prior to filing for registration. IARs were generally required to register by August 31, 2021, absent certain exemptions.

SEC Matters

SEC Increases Qualified Client Thresholds. On June 17, 2021, the SEC adopted amendments to the definition of “qualified client” under the Securities Act of 1933. The amendments increased the dollar amount thresholds for the “assets-under-management” test and the “net worth” test, respectively, from $1 million to $1.1 million and from $2.1 million to $2.2 million. Adjustments to the net worth and assets-under-management thresholds are made every five years to account for inflation.

The amendments became effective on August 16, 2021, and do not apply retroactively to contractual relationships entered prior to the effective date. Advisers to separately managed accounts and/or private funds relying on Section 3(c)(1) of the Investment Company Act of 1940 should review and update their investment advisory contracts and/or offering documents to reflect the new thresholds. Further details regarding the amendments can be found here.

SEC Adopts Modernized Marketing Rule for Investment Advisers. On December 22, 2020, the SEC adopted amendments to Rule 206(4)-1 under the Advisers Act to create a single, consolidated rule (Marketing Rule) that replaced separate advertising and cash solicitation rules. The Marketing Rule represents a significant overhaul of adviser marketing rules with a stated goal of shifting to “principles-based provisions designed to accommodate the continual evolution and interplay of technology and advice.” Among other changes, the Marketing Rule: (i) expands the scope of which communications, materials and activities are considered “advertisements”; (ii) replaces the per se violations of the Advisers Act with a more flexible, principles-based approach (potentially granting advisers the ability to use marketing materials in certain circumstances that include specific recommendations, testimonials, third-party ratings, etc.); and (iii) allows the use of hyperlinks and layered disclosures under certain conditions.

Advisers should reevaluate all methods by which they currently communicate with current and prospective clients, including their current marketing materials, solicitation arrangements, recordkeeping practices and social media policies. The Marketing Rule became effective on May 4, 2021, but advisers have until November 4, 2022, to comply with the new rule. More information regarding the Marketing Rule and the current transition period can be found here.

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 CPO-PQR and CTA-PR. Registered CPOs and CTAs must file Form CPO-PQR and Form CTA-PR, respectively, using the NFA’s EasyFile system. Registered CPOs must file Form CPO-PQR on a quarterly basis within 60 days of the quarters ending in March, June, and September, and within 90 days of the calendar year-end. Registered CTAs must file Form CTA-PR on a quarterly basis within 45 days of each quarter-end.

Advisers that are dually registered with the SEC and the CFTC may satisfy certain Form CPO-PQR filing requirements when they file Form PF. In order to take advantage of this, such advisers must file Form PF by the Form CPO-PQR deadline.

CPO and CTA 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.

CPOs should also check the date of the most recent disclosure document of each pool they operate. CPOs are generally prohibited from soliciting clients with a disclosure document that is more than 12 months old.

CFTC and NFA Matters

Changes to Form CPO-PQR. As of the March 31, 2021, reporting date, the CFTC has revised and streamlined Form CPO-PQR. The revised Form CPO-PQR now has one schedule (Schedule A), and all reporting CPOs must file the revised Form CPO-PQR every quarter, regardless of size. The CFTC has also attempted to make the form more user-friendly.

CFTC Establishes Climate Risk Unit. On March 17, 2021, Acting CFTC Chairman Rostin Behnam announced the establishment of the Climate Risk Unit (CRU). The CRU will assess the efficacy of derivatives products in addressing climate-related risks in the financial system. As part of its mission, the CRU will represent the CFTC in industry discussions to reduce carbon emissions worldwide. The CRU also intends to facilitate dialogue regarding emerging climate risks, aid in the development of new “net-zero” products, support development of climate-related market risk data and evaluate effectiveness of other tools in accelerating products and services that promote climate-friendly practices.

New Notice Requirements for CPOs. Effective as of June 30, 2021, CPOs are subject to newly adopted NFA Compliance Rule 2-50 (Rule 2-50). Rule 2-50 requires CPOs to report the following occurrences to the NFA with respect to each commodity pool they operate: (i) the inability to fulfill its obligations to investors or an unplanned liquidation of the pool; (ii) the inability to meet margin calls; (iii) the inability to make redemptions in accordance with subscription agreements; (iv) freezing redemptions in preparation for ceasing operations; and (v) receiving notice from a counterparty that the pool is in default. All pools operated by a CPO—including pools relying on the CFTC Regulation 4.13(a)(3) de minimis exemption—are subject to Rule 2-50. The NFA released Interpretive Notice 9080 to provide 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 Futures Commission Merchant (FCM)).

NFA Updates Branch Office Inspection Requirement and Physical Examination Requirement. In light of the pandemic, the NFA released a notice to allow Members who were temporarily working from home to exempt their home office from the definition of a “branch office.” The notice, released in March 2021, was made permanent starting September 23, 2021. In NFA Interpretive Notice 9002, the definition of a “branch office” was revised to exclude “any location where one or more associated persons (APs) from the same household live or rent/lease (e.g., a shared or co-workspace).”

The exemption for home offices was not the only change caused by the pandemic. Through the end of 2021, Members are allowed to conduct their annual inspection of each branch office remotely. While the annual inspection is still required, the ability to do so virtually is in line with current public health policies. The NFA will also allow Members to conduct virtual inspections of branch offices in 2022, if appropriate given applicable risks.

Financial Industry Regulatory Authority (FINRA) Matters

FINRA Amends Rules 5122 and 5123 to Include Retail Communications. Effective October 1, 2021, FINRA amended Rules 5122 and 5123 to expand the filing requirements of broker dealers. Under the previous versions of the rules, member firms were required to file any private placement memorandum (PPM), term sheet or other offering documents used in connection with a private placement offering. Under the amended rules, such firms are also required to file any “retail communications” used in connection with private placement offerings (e.g., pitchbooks, slide presentations, fact sheets). The amended rules effectively formalize a common practice—most broker dealers have historically filed such retail communications simultaneously alongside the required PPMs or term sheets.

Digital Assets Matters

El Salvador Adopts Bitcoin as Legal Tender. On September 7, 2021, EL Salvador became the first country to adopt Bitcoin as legal tender. With the change, each company in El Salvador became required to accept Bitcoin as payment, and each citizen was gifted $30 in Bitcoin for utilizing the government’s e-wallet. President Nayib Bukele hoped the adoption of Bitcoin would stimulate the country’s economy in part by reducing transaction costs and increasing efficiency in international transactions. El Salvador remains the only country to adopt such a policy.

Rulemaking Petition Sent to SEC on Non-Fungible Tokens (NFTs). On April 12, 2021, Arkonis Capital, a registered broker dealer, submitted a rulemaking petition to the SEC requesting guidance on NFTs. In the petition, Arkonis posits scenarios under which an NFT may be deemed a “security”. They also argue 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 considered a security.

Arkonis further states that should the SEC deem an NFT to be a security, the platform facilitating the sale and/or trading of such NFT could be required to register with the SEC as an exchange. Given these regulatory implications, Arkonis petitioned the SEC to publish guidance regarding when an NFT is a security and the resulting registration requirements. As of December 2021, the SEC has not released the requested guidance.

SEC Chair Gensler Discusses the Regulation of Cryptocurrency Under Existing Authorities. On September 14, 2021, Gary Gensler, the SEC Chair, testified before the Senate Banking Committee regarding the SEC’s authority to regulate the cryptocurrency market. During the testimony, Gensler responded to questions about gaps in the current regulatory regime by stating the SEC and the CFTC have “a great deal of authority” with regard to digital assets and “a great deal of clarity” in determining which digital assets meet the definition of a security. The gaps, he clarified, exist in the coordination amongst the different regulatory agencies—specifically, the SEC, the CFTC and the banking agencies.

Gensler also testified in October before the House Committee on Financial Services regarding cryptocurrency regulation. When asked about whether certain cryptocurrencies are securities, Gensler declined to comment on any specific token and reiterated that any token that passes the Howey Test is a security. Specifically, he stated “[T]he securities laws are quite clear. If you’re raising money from somebody else, and the investing public has a reasonable anticipation of profits based on the efforts of others, that fits within the securities law.”

First Bitcoin Futures ETF Launches. On October 18, 2021, ProShares launched the Bitcoin Strategy ETF, the first Bitcoin-focused exchange traded fund listed on a national exchange. Trading under “BITO”, the fund does not directly invest in Bitcoin but provides exposure to Bitcoin futures contracts. As of November 11, 2021, BITO had net assets of over $1.4 billion. Two other national Bitcoin futures ETFs launched shortly after the launch of BITO.

SEC Rejects Spot Bitcoin ETF. On November 12, 2021, the SEC rejected a proposed rule change to list shares of the VanEck Bitcoin Trust on the Cboe BZX Exchange. In its rejection, the SEC stated that the exchange did not meet its burden as a national securities exchange under the Securities Exchange Act of 1934 “to prevent fraudulent and manipulative acts and practices” and “to protect investors and the public interest.” The ruling is consistent with past statements from SEC Chair Gensler and other SEC actions demonstrating a preference for Bitcoin futures ETFs over spot Bitcoin ETFs.

Coinbase Files for Futures and Derivatives Trading. On September 16, 2021, Coinbase confirmed that it filed an application with the NFA to register as an FCM. As an FCM, Coinbase would be able to offer cryptocurrency futures and derivatives trading to U.S. persons on its platform. The application is still pending.

Ripple Lawsuit. In December 2020, the SEC sued Ripple Labs Inc. and two of its executives for allegedly conducting a $1.3 billion unregistered securities offering for XRP, its token. The SEC claims that XRP is a security because it was distributed by Ripple in a centralized manner and represents an investment in the company. Ripple disputes these claims, asserting that the SEC failed to release proper guidance on digital asset regulation and is attempting to utilize an outdated regulatory scheme on a novel industry. The Ripple case is ongoing, and its outcome could significantly affect the digital asset industry in the U.S.

SEC Fines Poloniex for Operating Unregistered Digital Asset Exchange. On August 9, 2021, the SEC announced that Poloniex LLC agreed to pay more than $10 million to settle charges of operating an unregistered digital asset exchange. The order states that Poloniex’s platform facilitated buying and selling digital assets, including digital assets that met the definition of a security. While operating the exchange, Poloniex instituted an internal review mechanism where it determined how likely certain digital assets were to be deemed securities. However, the SEC stated that Poloniex offered the ability to trade digital assets that were at “medium risk” under Poloniex’s policy and, as a result, certain digital assets meeting the definition of a security were available to trade on the platform.  This case reinforces the SEC’s authority over the digital asset industry, but the SEC did not go into detail on which specific digital assets met the definition of a security. 

CFTC Fines Kraken for Offering Margin Trading in the U.S. On September 28, 2021, the CFTC issued an order settling charges against Payward Ventures, Inc. d/b/a Kraken for illegally offering margined retail commodity transactions in digital assets and failing to register as an FCM. From June 2020 to July 2021, Kraken allowed customers to purchase digital assets (including Bitcoin) using margin. The CFTC found that “actual delivery” of the underlying assets did not occur, meaning the transactions met the definition of “retail commodity transactions.” Such transactions fall under the CFTC’s jurisdiction and are treated similarly to traditional futures contracts. The CFTC found the transactions to be unlawful because they did not take place on a designated contract market and Kraken acted as an unregistered FCM by soliciting and accepting the transactions.

BitMEX Moves All Operations Offshore as Remedial Measures in CFTC Action. On August 10, 2021, the CFTC announced that a U.S. district court entered a consent order against five companies that operated the BitMEX cryptocurrency derivatives trading platform. The order required BitMEX to pay a $100 million civil monetary penalty. As part of its remedial measures, BitMEX no longer maintains any substantive operations or business functions in the U.S. BitMEX also certified to the CFTC that anyone located in the U.S. is prohibited from accessing the platform. BitMEX’s remedial measures places it in line with other platforms offering digital asset derivative transactions solely outside the U.S.

Additional Compliance Matters

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 that manage private funds are generally required to distribute audited financial statements to each fund investor within 120 days of each year-end.

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.

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 must update the entire form.

Blue Sky Filings.  Fund managers should review their state blue sky filings to ensure they have met any applicable state renewal requirements. Note that issuers selling securities in New York in reliance on an exemption under Regulation D are required to file Form D and pay related filing fees through the Electronic Filing Depository. As of February 1, 2021, New York does not accept any Form 99 submissions and no longer requires issuers to file a notarized Form U-2.

Regulatory Alert: SEC Expands Definition of Accredited Investor

Written by Kevin Cott on . Posted in Digital Assets & Cryptocurrency Funds, Hedge Funds, Regulatory & Compliance, Venture Capital, Private Equity & Real Estate Funds.

On August 26, 2020, the U.S. Securities and Exchange Commission (“SEC”) adopted amendments to the definition of “accredited investor” under the Securities Act of 1933. As previously covered, the amendments expand the definition of an accredited investor in an effort to more effectively identify institutional and individual investors that have the knowledge and expertise to participate in private capital markets. Notably, the updated definition of an accredited investor will allow more investors to participate in hedge funds and other alternative investment funds by adding new categories of qualifying natural persons and entities. The amendments became effective on December 8, 2020 and can be viewed here.

Below is a summary of key changes to the definition of an accredited investor included in the amendments:

  1. Credentialed Individuals. Individuals may now qualify as accredited investors based on certain professional certifications, designations or credentials. Initially, the SEC designated the Series 7, Series 65 and Series 82 licenses as qualifying credentials. The SEC may add other qualifying credentials pursuant to future orders.
  2. Knowledgeable Employees. “Knowledgeable employees”, as defined in Rule 3c-5(a)(4) under the Investment Company Act of 1940 (“Company Act”), of private investment funds will be deemed accredited investors when making investments in such funds. Notably, expanding the definition of an accredited investor to include knowledgeable employees will allow funds with assets of $5 million or less to permit such employees to invest in the funds without jeopardizing the fund’s status as an accredited investor (i.e., an entity in which all equity owners are accredited investors).
  3. Additional Entities. An accredited investor now includes SEC- and state-registered investment advisers, exempt reporting advisers, rural business investment companies and limited liability companies with more than $5 million in assets. The new definition also adds a category for any entity, including Indian tribes, governmental bodies, funds, and entities organized under the laws of foreign countries, that (i) own “investments,” as defined in Rule 2a51-1(b) under the Company Act, in excess of $5 million; and (ii) that was not formed for the specific purpose of investing in the securities offered.
  4. Family Offices. Certain “family offices” with at least $5 million in assets under management and their “family clients,” as each term is defined under the Investment Advisers Act of 1940, will now qualify as accredited investors.
  5. Spousal Equivalents. Spousal equivalents may now pool their finances for the purpose of qualifying as accredited investors. The SEC specifically noted that spousal assets do not need to be held jointly to be included in the pooled finances calculation.

Private investment funds and other issuers that currently rely on Regulation D of the Securities Act to offer securities to investors should work with legal counsel to amend their subscription documents and offering materials to reflect the updated definition of an accredited investor. If you have any questions regarding the amendments to the accredited investor definition, please do not hesitate to contact Kevin Cott at kevin@cottlawgroup.com.

SEC Approves Modernizing Amendments to Accredited Investor Definition

Written by Kevin Cott on . Posted in Digital Assets & Cryptocurrency Funds, Hedge Funds, Regulatory & Compliance, Venture Capital, Private Equity & Real Estate Funds.

On August 26, 2020, the U.S. Securities and Exchange Commission (the “SEC”) adopted amendments to the definition of “accredited investor” under the Securities Act of 1933 (the “Act”). The SEC proposed the amendments on December 18, 2019 in an effort to more effectively identify institutional and individual investors that have the knowledge and expertise to participate in private capital markets. Ultimately, the updated definition allows more investors to participate in private offerings by adding new categories of natural persons and entities that may qualify as accredited investors.

The SEC’s press release on the amendments and the full text of the final rule can be found here.  In addition, our previous blog post discussing the proposed amendments in detail can be found here.

Below is a summary of the amendments to the accredited investor definition as provided by the SEC. The amendments are set to become effective 60 days after publication in the Federal Register.

The amendments to the accredited investor definition in Rule 501(a) of the Act:

  1. Add a new category to the definition that permits natural persons to qualify as accredited investors based on certain professional certifications, designations or credentials or other credentials issued by an accredited educational institution, which the SEC may designate from time to time by order. In conjunction with the adoption of the amendments, the SEC designated by order holders in good standing of the Series 7, Series 65, and Series 82 licenses as qualifying natural persons.  This approach provides the SEC with flexibility to reevaluate or add certifications, designations, or credentials in the future.  Members of the public may wish to propose for the SEC’s consideration additional certifications, designations or credentials that satisfy the attributes set out in the new rule;
  2. Include as accredited investors, with respect to investments in a private fund, natural persons who are “knowledgeable employees” of the fund;
  3. Clarify that limited liability companies with $5 million in assets may be accredited investors and add SEC- and state-registered investment advisers, exempt reporting advisers, and rural business investment companies (RBICs) to the list of entities that may qualify;
  4. Add a new category for any entity, including Indian tribes, governmental bodies, funds, and entities organized under the laws of foreign countries, that own “investments,” as defined in Rule 2a51-1(b) under the Investment Company Act, in excess of $5 million and that was not formed for the specific purpose of investing in the securities offered;
  5. Add “family offices” with at least $5 million in assets under management and their “family clients,” as each term is defined under the Investment Advisers Act; and
  6. Add the term “spousal equivalent” to the accredited investor definition, so that spousal equivalents may pool their finances for the purpose of qualifying as accredited investors.

If you have any questions regarding the amendments to the accredited investor definition, please do not hesitate to contact Kevin Cott at kevin@cottlawgroup.com.

SEC Proposes Updates to Accredited Investor Definition

Written by Kevin Cott on . Posted in Digital Assets & Cryptocurrency Funds, Hedge Funds, Regulatory & Compliance, Venture Capital, Private Equity & Real Estate Funds.

On December 18, 2019, the U.S. Securities and Exchange Commission (the “SEC”) issued a press release highlighting proposed amendments to the definition of an “accredited investor” under the Securities Act of 1933 (the “Act”). We expect private fund managers to embrace the proposed changes, as the amendments seek to permit more investors to participate in private capital markets by including new categories of qualifying natural persons and entities and solidifying previous interpretive positions held by the SEC. Below is a short summary of the notable proposed additions to the definition. The SEC’s full press release and the complete proposal can be found here.

  1. Professional Certificates and Knowledgeable Employees of a Fund

The proposed definition will add two new categories applicable to individual investors. First, the new definition will allow natural persons who hold professional certifications to be considered accredited investors regardless of their financial condition. The SEC states in the proposal that it expects this category will initially include holders of Series 7, 65, or 82 licenses but mentions holders of other degrees and certifications (CFA, CPA, MBA) as possible inclusions as well.

Second, the new definition will include a specific carve out for “knowledgeable employees” of a private fund. The carve out will be similar to the current category for directors, executive officers, or general partners of the issuer but will apply more broadly to include knowledgeable employees as currently defined in Rule 3c-5 of the Act.

  1. Registered Investment Advisors, RBICs, and LLCs

While the current definition of accredited investor includes various entity types, the SEC is seeking to add three additional entity types that it feels are sophisticated enough to be considered accredited. Specifically, the SEC is proposing to add state and SEC registered investment advisers, approved rural business investment companies (as defined in the Consolidated Farm and Rural Development Act), and certain limited liability companies.

The inclusion of certain LLCs is of particular note because the current definition does not specifically refer to LLCs. Under the new definition, the SEC will add LLCs to the list of entities that are considered accredited as long as they have total assets in excess of $5 million and were not formed for the specific purpose of acquiring the securities being offered.

  1. Certain Family Offices and Family Clients

The SEC is also proposing a new category of accredited investors that includes any “family office” with at least $5 million in assets under management and its “family clients,” as those terms are defined under the Advisers Act. The SEC is also proposing that the family office must not be formed for the specific purpose of acquiring the securities offered and that the family office be directed by a person with the requisite knowledge and experience in financial and business matters to ensure the family office is capable of evaluating the merits and risks of the prospective investment.

As justification for the addition, the SEC believes that these family offices have the minimum amount of assets under management to sustain the risk of loss and that the additional requirements will safeguard against improper reliance. The SEC generally expects all family offices to be accredited under the new definition.

  1. Entities Owning at Least $5 Million in Investments

In addition to including the enumerated entities above, the SEC is also proposing a catch-all category that will allow any entity owning investments in excess of $5 million that is not formed for the specific purpose of acquiring the securities being offered to be deemed accredited. This new category is meant to include all existing entity forms not already contemplated by the current definition, such as Indian tribes or governmental bodies.

  1. Codification of SEC Interpretations of the Current Rule

As part of the proposed definition, the SEC is codifying certain existing interpretations of the current definition. Of note, the SEC will codify two important interpretations applying to entities owned solely by accredited investors and individuals pooling combining finances with spousal equivalents.

The current definition of accredited investor includes any entity in which all the equity owners are accredited investors. However, the definition does not state whether one should look through any underlying entities that are not natural persons. Consistent with the SEC’s existing interpretation of the current definition, the proposed definition specifically states that one may look through any equity owners that are entities to the ultimate natural person owners.

The current definition allows “spouses” to pool together their finances to meet the relevant thresholds. However, the definition does not explicitly extend to spousal equivalents such as domestic partnerships or civil unions. Consistent with its current interpretation, the SEC is proposing this amendment because it sees no reason to distinguish between these types of relationships and believes that the new definition will remove any unnecessary barriers to investment opportunities for spousal equivalents.

Issues for US Managers Trading on Offshore Cryptocurrency Derivative Exchanges

Written by Kevin Cott on . Posted in Digital Assets & Cryptocurrency Funds.

For US digital assets fund managers that want to trade on offshore cryptocurrency derivative exchanges, a significant challenge is that such exchanges are often limited to non-US persons or “eligible contract participants” (ECPs) to avoid US commodities regulations. Similarly, many offshore non-derivative exchanges and issuers of initial coin offerings (ICOs) restrict their participants to non-US persons to avoid US securities regulations.

A creative solution for US managers attempting to participate in offshore non-derivative exchanges and ICOs involves utilizing an arm’s length transaction free of ownership (i.e. a participation agreement) between an offshore fund that is a permitted non-US person and a US investment vehicle. The participation agreement is a novel structure that may allow US managers to take advantage of some investment opportunities generally not available to US investors. However, would the same approach succeed with an offshore exchange for cryptocurrency derivatives/futures? Many offshore cryptocurrency derivatives exchanges carry the same “no US persons” requirement. However, in addition to avoiding any potential US securities regulations and tax concerns, these exchanges are also trying to comply with CFTC rules and regulations.

Regulatory Concerns of Offshore Cryptocurrency Derivative Exchanges

The CFTC considers cryptocurrency to be a commodity and has the authority to regulate exchanges for cryptocurrency derivatives and the funds that invest in them. As a result, many of these exchanges do not allow US participants except for those who are ECPs as defined by the CFTC. Derivatives exchanges limited to ECPs may not be required to register with the CFTC. Therefore, a US manager could potentially gain access to these exchanges by either (1) managing a US fund that is considered an ECP or (2) entering into a participation agreement with a non-US fund that is allowed on the exchange.

Of the two above options, the latter is certainly preferable as many managers will not be able to qualify their funds as ECPs. However, even if the participation agreement does allow US managers to bypass an exchange’s no US person requirement, it may still cause issues for the participating funds and the exchange. If the fund trading on the exchange is considered a commodity pool with US customers, then the CFTC may have a cause of action against the exchange for allowing non-ECP, US customers access to an unregulated derivatives exchange. As a result, the exchange would be required to register with the CFTC as a futures commission merchant (FCM), and any offshore exchange seeking to avoid US compliance obligations would undoubtedly not allow any participants who would bring about registration requirements.

There is a chain of analysis regarding whether, under the participation agreement structure, the US fund manager or the exchange would be subject to CFTC registration and disclosure requirements. First, is the US fund considered a commodity pool as defined by the CFTC? Second, if so, is the special purpose vehicle (SPV) serving as the corresponding offshore fund (with which the US fund enters a participation agreement also a commodity pool that is subject to CFTC regulation? Third, if the SPV is required to register under the CFTC, will the exchange be subject to FCM registration and disclosure requirements?

Based off existing CFTC rules and guidance, there is no clear answer as to whether the US entity that has a participation agreement with the offshore SPV would be considered a commodity pool. However, if the US entity is deemed a commodity pool, then the SPV and the exchange will likely be subject to CFTC registration and disclosure requirements.

  1. Is the US fund a commodity pool?

The CFTC defines “Commodity Pool” to “include any investment trust, syndicate, or similar form of enterprise operated for the purpose of investing in commodity interests.” This definition includes commodity pools that invest in commodity interests indirectly though other commodity pools. Beyond the language in the statute, we also have CFTC guidance stating that the term “created for the purpose of” should be interpreted broadly and not interpreted to exclude investment vehicles created primarily for other purposes.

The question, then, is whether the CFTC would deem the US entity as created for the purpose of investing in commodity interests given the statutory definition and past guidance. Here, although the fund technically would not “invest” in anything (it’s more a party to a contractual agreement), it would be created with the ultimate purpose of allowing US investors access to returns on commodity interests. With this mind, the CFTC would have a reasonable argument that the US entity is a commodity pool because it is effectively an investor in another commodity pool (the SPV) even if the “investment” is not structured as a traditional shareholder interest. In other words, the CFTC can argue that the US entity was created for the purpose of investing in commodity interests, even though it does no traditional investment on its own. Therefore, while there is an argument to be made on both sides, there is no guarantee that the CFTC will conclude that the US entity falls outside of their jurisdiction. Moving forward assuming the CFTC will conclude otherwise could be risky for the US fund manager and the exchange.

  1. Is the SPV subject to CFTC registration and disclosure requirements?

If the US entity is considered a commodity pool, there is likely a disclosure/registration requirement for the offshore SPV. The reasoning is three-fold.

First, a foreign entity with US customers that trades on a foreign exchange is subject to CFTC registration requirements. Likewise, as discussed above, if the US entity is considered a commodity pool, then the CFTC will likely argue that it is a commodity pool because the US entity participates in another commodity pool (the SPV). Therefore, the US entity could be a “customer” of the SPV in the CFTC’s eyes and require the SPV to register.

Second, there is some relief from disclosure, reporting and recordkeeping requirements for certain foreign pools that potentially  sheds some light on the CFTC’s view of which non-US pools should be exempt from registration. CFTC advisory 18-96 states that a CPO does not have to disclose information on exclusively foreign pools that is manages. In the participation agreement structure, the SPV will likely be managed by a different CPO (management entity), and this exemption may not directly apply. However, it does offer insight into the CFTC’s concern with foreign pools and how they are likely to interpret the participation agreement scenario.

To take advantage of the relief, the CPO must follow certain requirements designed to ensure the foreign pool is removed from US involvement. There are three requirements of note that offer guidance here. First, the foreign pool must have no shareholders or other participants that are US persons. Second, the pool may not receive, hold, or invest any capital directly or indirectly contributed from sources in the US. Third, neither the pool, the manager, or any affiliate of either may undertake any marketing activity that could attempt to solicit participation from US persons.

Based off these three requirements, we see that the CFTC is concerned with pools that have even indirect ties to US persons through either affiliate marketing or indirectly contributed US capital. Therefore, since a participation agreement involves the SPV receiving some sort of capital from the US entity, the CFTC may see the transaction as one that brings about registration and disclosure requirements.

Third, the regular exemption to non-US managers may not apply to the foreign manager of the SPV. Generally, foreign CPOs with foreign customers that trade on foreign exchanges are not subject to registration requirements. However, if the foreign manager does have US customers, then it is only exempt if, among other things, it executes trades through a registered FCM.  As discussed above, the foreign pool may be determined by the CFTC to have a US customer base. Therefore, the manager would only be exempt if the exchange it uses is a registered FCM – the exact requirement many offshore cryptocurrency derivative exchanges will be trying to avoid.

  1. Would the foreign cryptocurrency derivative exchange be subject to CFTC registration requirements?

As stated above, if the US entity is considered a commodity pool under CFTC jurisdiction, then the SPV may also be subject to CFTC regulations. In that case, the CFTC would require the foreign cryptocurrency derivative exchange to register as an FCM.

The CFTC generally has jurisdiction over exchanges not limited to ECPs. However, these exchanges fall outside of CFTC jurisdiction if the exchange is domiciled outside of the US and only has non-US customers.

If the participation agreement structure is used, it is likely that the SPV attempting to trade on the exchange is not an ECP. Further, if the SPV is required to register with the CFTC, it is likely because the CFTC sees the SPV as having ties to US customers. Therefore, if the SPV trades on the exchange, the CFTC will see that unregulated trading is occurring and could go after the exchange for not being registered.

Conclusion

To summarize, the participation agreement structure is a unique method potentially allowing US-based investors to participate in offshore cryptocurrency exchanges and ICOs. However, the participation agreement may not allow the same investors to participate in offshore cryptocurrency derivative exchanges as the CFTC may exert registration and disclosure requirements on the participating funds and the exchange, meaning the exchange would not want to allow the arrangement in the first place.

ICOs: Non-US Persons and Investor Eligibility Considerations

Written by Kevin Cott on . Posted in Digital Assets & Cryptocurrency Funds, Uncategorized.

As blockchain continues to evolve as a disruptive technology, the regulatory environment surrounding initial coin offerings (ICOs) by companies issuing digital tokens to investors remains uncertain and subject to much debate. As a result, many companies issuing ICOs are shunning US investors altogether to avoid US securities laws. Below, we will discuss the definition of a “US person” under Regulation S of the Securities Act, which effectively determines who can invest in such ICOs and the restrictions placed on such investors. Specifically, under what circumstances, if any, will a cryptocurrency hedge fund affiliated with a US manager be permitted to participate in unregistered ICOs? Further, if allowed to participate in unregistered ICOs, when will a participating cryptocurrency fund be permitted to resell the securities on the secondary market?

Definition of a US Person – Who Can Invest?

Many ICOs restrict their offerings to non-US persons. In doing so, these issuers generally use the Regulation S definition of a “US person” to determine investor eligibility. In most cases, determining whether an investor is a US person is straightforward, as the investor will either be a non-US resident or a company formed outside the US by non-US residents. However, the determination is not as clear when a foreign entity can be traced back to a US person. The definition, provided below, contains a somewhat ambiguous example at the end that, depending on one’s interpretation, could either permit or prohibit US-managed offshore cryptocurrency hedge funds from participating in certain foreign ICOs.

Under Regulation S, a US person is:

(i) Any natural person resident in the United States;

(ii) Any partnership or corporation organized or incorporated under the laws of the United States;

(iii) Any estate of which any executor or administrator is a U.S. person;

(iv) Any trust of which any trustee is a U.S. person;

(v) Any agency or branch of a foreign entity located in the United States;

(vi) Any non-discretionary account or similar account (other than an estate or trust) held by a dealer or other fiduciary for the benefit or account of a U.S. person;

(vii) Any discretionary account or similar account (other than an estate or trust) held by a dealer or other fiduciary organized, incorporated, or (if an individual) resident in the United States; and

(viii) Any partnership or corporation if:

         (A) Organized or incorporated under the laws of any foreign jurisdiction; and

         (B) Formed by a U.S. person principally for the purpose of investing in securities not registered under the Act, unless it is organized or incorporated, and owned, by accredited investors             (as defined in § 230.501(a)) who are not natural persons, estates or trusts.

The last example above is the most relevant to US-based fund managers that sponsor offshore funds to accommodate non-US investors and tax-exempt US investors. The crux of the issue is whether an offshore cryptocurrency hedge fund would qualify as a US person and be prohibited from investing in an ICO limited to non-US persons.

There are two main considerations in determining whether an offshore cryptoccurency fund would qualify as a US person under (viii)(B) above; specifically, whether the offshore fund is formed by a US person or, in the alternative, if the offshore fund is owned by accredited investors who are not natural persons, estates, or trusts.1

Formed by a US Person

Whether an offshore fund is formed by a US person can be tricky. Typically, when sponsoring an offshore fund entity, the US-based manager will instruct its offshore counsel or some other offshore organization to facilitate the process of forming the entity. However, if the ICO looks through the literal formation of the fund and concludes that the fund is effectively formed for the benefit of the US manager, such US manager that established an offshore fund, either standalone or in a master-feeder or mini-master scenario2 , may have to overhaul its overall structure and create a non-US-based management company. Each new offshore management company would itself not be considered a US person and, arguably, could form an offshore hedge fund without concern for the interpretive issue created by (viii)(B)3.

Owned by Accredited Investors who are not Natural Persons

Even if the ICO issuer determines that the offshore fund was formed by a US person, the fund itself may still avoid qualification as a US person if it is owned entirely by accredited investors who are not natural persons.

In the standalone fund context, the fund must simply limit its investor pool to accredited entities. This is mostly impractical in the ICO realm as it may be difficult to entice institutional investors or other hedge funds to invest in a fund that is focused on such a cutting-edge and volatile investment opportunity. Accordingly, other fund structures may provide more favorable conditions.

In a mini-master structure, the feeder fund, as the non-US entity in the structure, would similarly have to prohibit individuals from investing in it. This presents the same problem as the standalone fund in that it may be impractical to limit a fund of this type to entity investors.

In a master-feeder structure, the two feeder funds are technically the only investors in the master fund. If the master fund is deemed to be formed by a US person, each feeder fund would have to be an accredited investor for the master fund to not be considered a US person. Each feeder fund may meet the requirements of an accredited investor by limiting its own investors to only accredited investors. In that case, since the master fund’s investor pool only consists of the feeder investors, each investor in the master fund would be an accredited investor that is not a natural person. Notwithstanding the foregoing, many ICOs contain additional verbiage prohibiting participation by entities that are US persons or that are beneficially owned by any US persons (the latter of which would be problematic for master-feeder structures regardless of accredited investor requirements). Fund managers will therefore need to read the ICO offering details closely to confirm whether a master-feeder structure limited to accredited investors is a viable option.

Restrictions Placed on Investors

Even if an investor qualifies as a non-US person under Regulation S and can participate in the ICO, it may still be subject to additional restrictions.

Regulation S provides a safe harbor for securities offerings that take place outside of the United States. Securities that rely on the safe harbor are exempted from US securities registration requirements. To qualify for the exemption, the securities must be offered in an offshore transaction and the issuer must make no directed selling efforts in the United States. Both requirements apply to all issuers seeking safe harbor under the regulation. However additional requirements may apply depending on the type of security being offered and the equivalent category the security falls under.

Under Regulation S, securities are split into 3 categories, each with its own set of limitations.

Category 1 securities must be offered in a foreign offering and issued by non-US issuers who believe that no substantial US market interests exist for their securities. No additional restrictions are placed on Category 1 securities.

Category 2 securities include equity securities of a reporting foreign issuer and debt securities of a reporting or a non-reporting foreign issuer. Category 2 securities are subject to a 40-day distribution compliance period.

Category 3 securities are securities that do not fall into either Category 1 or Category 2.

An offshore ICO would not fall under Category 1 because a substantial US interest most likely exists for the corresponding coin4. Further, the ICO would not fall under Category 2 as the issuer of the ICO is likely not a reporting issuer and the security is not a debt security. Consequently, an offshore ICO would typically fall under Category 3 of Regulation S and carry the corresponding restrictions.

The Category 3 restrictions most relevant to investors in ICOs are the resell restrictions. A non-reporting issuer of Category 3 securities must restrict its offering for a one-year distribution compliance period that generally begins at closing. Resales of these securities are also subject to the distribution compliance period. During the compliance period, no securities can be sold/resold to US persons or to a non-US person for the benefit of a US person. Therefore, investors in the ICO may only resell their security to non-US persons for one year from closing and can resell their security to US-persons after that one-year period ends.

Conclusion

As a novel instrument, ICOs provide fund managers with unique investment opportunities. However, ICOs present equally unique challenges to fund managers due to the unsettled regulatory environment surrounding them. As such, US fund managers should take care to consult qualified legal counsel early during the fund launch process and for ongoing help with evaluating eligibility to invest in certain ICOs.

 

[1] If the fund is an offshore fund, it automatically meets the requirement of (viii)(A).

[2] US based managers typically use either a master-feeder or a mini-master structure. The master-feeder structure involves two feeder funds, one based in the US and one based outside of the US, that both invest all their capital in a master fund that is also based outside the US. The mini-master structure involves an offshore feeder fund that invests solely in a US master fund.

[3] However, this assumes that the ICO only looks through to the management company of the fund investing in the ICO and not to the US-based, affiliated management companies and/or principals of those companies.

[4] A substantial US market interests exists “where (i) U.S. securities exchanges and NASDAQ in the aggregate constituted the single largest market for such class of securities in the issuer’s prior fiscal year, or (ii) 20% or more of trading in the class of equity securities during such period occurred in such U.S. markets and less than 55% of trading in such securities took place during that period through the facilities of the securities markets or a single foreign country (17 CFR 230.902).” An offshore ICO would generally qualify for (ii) in the preceding definition as a significant portion of trading in the asset class takes place in the US.



SEC Cyber Unit: Impact on Initial Coin Offerings and Cryptocurrency Fund Managers

Written by Kevin Cott on . Posted in Digital Assets & Cryptocurrency Funds.

In July, we discussed the SEC’s assertion that an Initial Coin Offering (ICO) could constitute a securities offering, subject to the SEC’s jurisdiction and compliance with federal and state securities law. Last week, the SEC issued a press release announcing its creation of the Cyber Unit, a new enforcement initiative that will impact the cryptocurrency space. The creation of the Cyber Unit is timely partially due to the SEC’s report on the regulation of ICOs and partially due to the SEC’s recent disclosure that it was hacked in 2016. The SEC stated the Cyber Unit has been in the planning stages for months and will complement the SEC’s efforts to create a cybersecurity working group to coordinate information sharing and incident response efforts throughout the SEC. The Cyber Unit will focus on cyber-related:

  1. Market manipulation schemes;
  2. Hacking to obtain nonpublic information;
  3. Violations involving distributed ledger technology and ICOs;
  4. Misconduct on the dark web;
  5. Intrusions into retail brokerage accounts; and
  6. Threats to trading platforms and market infrastructure.

ICO Regulation

The SEC’s first step in regulating ICOs was its initial report in July that contained the SEC’s assertion of jurisdiction in the ICO space. The creation of the Cyber Unit is the next step in the SEC’s attempt to demonstrate to the cryptocurrency community that it intends to take ICOs and other blockchain assets seriously, especially given the broad powers the Cyber Unit possesses. Now that the SEC has firmly established its presence in the ICO space, it is unlikely any new ICOs conducted in violation of federal securities law will receive leeway in SEC enforcement. Entities planning on conducting an ICO, or otherwise dealing in virtual currencies, should consult qualified legal counsel to ensure compliance with the relevant securities laws.

Starting a Cryptocurrency Fund: Digital Asset Storage Methods

Written by Kevin Cott on . Posted in Digital Assets & Cryptocurrency Funds.

Given the rise of cryptocurrency hedge funds and other investment products, Bitcoin and cryptocurrency fund managers are having to make decisions regarding optimal storage methods to suit their particular needs when holding and trading cryptocurrencies and other blockchain assets. Unlike securities or futures held in custody of a registered and established broker-dealer or futures commission merchant (FCM), cryptocurrency transactions are often executed through an exchange, but held elsewhere.  In this post, we will discuss advantages and disadvantages of mainstream storage methods currently available to fund managers.

First, it is worth addressing public key encryption. Public key encryption is the type of encryption most mainstream cryptocurrencies utilize as a security mechanism. In public key cryptography, an individual has a public key and a private key. A public key is widely accessible to the general community, and it allows an individual to receive cryptocurrency sent to the public key’s corresponding address. A private key, however, should only be accessed by an account holder. The private key is the only key capable of decrypting information or assets sent to an account holder’s public key. Anyone who controls a private key controls the assets contained in a cryptocurrency storage wallet. In its simplest terms, a public key allows a fund to receive cryptocurrency, and a private key allows a fund to access its account to withdraw or send cryptocurrency.

Hot Storage

Generally speaking, hot storage is connected to the internet. On the spectrum of convenience and safety, hot storage will generally be more convenient at the expense of safety. Given security concerns, capital and cryptocurrencies normally move in and out of hot storage wallets as opposed to being stored for any significant amount of time.

Exchange Storage

Storing cryptocurrencies on an exchange is likely the most convenient method of storage. As opposed to dealing with and tracking public and private keys,. storing cryptocurrencies on an exchange allows one to simply login with a username and password to trade and access funds, much like a traditional broker-dealer or FCM. The downside of storing cryptocurrencies on an exchange is that you do not have full control over your coins (i.e., you may not have access to your private key). As with all online storage, exchanges are vulnerable to hacks (e.g., the Mt. Gox $450 million hack). Also, the lack of access to a private key could potentially result in the loss of an entire portfolio if the exchange experienced data failure or a sudden shutdown.

Online Wallet

Similar to exchange storage, online wallets are convenient. Online wallets also typically partner with exchanges to allow account holders to trade various cryptocurrencies. Unlike most online exchanges, online wallets typically give account holders full control over public and private keys. Like exchange storage, however, online wallets are vulnerable to hacks due to internet connectivity.

Desktop Wallets

Desktop wallets are generally considered the safest method of hot storage. A desktop wallet is typically downloaded online and utilized to store cryptocurrency locally. In a typical desktop wallet, an individual’s private key will solely be stored locally on the user’s hard drive; however, desktops wallets must connect to the internet to allow the trading of cryptocurrencies. This can expose the desktop wallet to malicious software and hacking efforts. Additionally, if the local machine were to experience hardware failure, a fund could potentially lose all of its coins or incur substantial data recovery expenses.

Cold Storage

Cold storage concerns the process of keeping cryptocurrencies stored completely offline. While cold storage is by far a safer method of storage, it is substantially less convenient than hot storage and it still has pitfalls in security.

Paper Wallet

One of the more secure ways to store any cryptocurrency is through the use of a paper wallet. To generate a paper wallet, a fund can generate a public and private key completely offline on a printable piece of paper. The benefit of this storage is that there is no potential for the key to be hacked due to the lack of connection to the web and storage is as simple as securing a piece of paper. The downside, however, is that all of your funds are solely held on a sheet of paper (or another physical instrument) that can be destroyed, stolen, or simply lost. Additionally, paper wallets are far less convenient storage methods compared to hot storage, and a fund would likely not keep short-term trading assets held on paper wallets.

Hardware Wallet

A hardware wallet is a purposefully designed cryptocurrency wallet. Unlike a wallet placed on a USB drive or other bootable drives, hardware wallets are dedicated, self-contained pieces of hardware that generate their own public and private keys without the use of any outside software. The private keys are typically stored and encrypted in a protected area of the hardware wallet’s microcontroller and non-transferrable out of the hardware wallet. Hardware wallets are also generally immune to computer viruses and malicious malware and can be secured through additional password protection. While hardware wallets are among the safest storage options available, they can still be stolen (even if the funds cannot be accessed), destroyed, or otherwise damaged, resulting in a loss of the contents of the wallet.

Vault Storage

                Vault storage is a long-term storage method that contains elements of hot and cold storage. Some exchanges (such as Coinbase and Xapo) provide vault storage services as an additional security service. In vault storage, exchanges create a private key completely offline for an account-holder’s vault. Fund managers can then purchase cryptocurrency on an exchange and send the cryptocurrency to the vault’s public address. Vaults readily accept incoming transactions, but require advanced identity confirmation for all outgoing transactions. Coinbase and Xapo both provide a 48-hour delay on withdrawal transactions, can require multiple approvers for any given transaction and require multiple forms of proof of identity. While vault storage suffers from the same control issues as exchange storage, vault storage can eliminate some of the risks associated with destruction or damage to paper and hardware wallets. Additionally, some vault storage facilities insure vault-stored assets from theft and/or destruction

Final Considerations

Given the digital nature of cryptocurrencies and other blockchain assets, all storage methods will possess vulnerabilities. Funds can, however, mitigate the risks associated with the above-listed storage methods in the following ways:

  1. Two-factor authentication (i.e. requiring a password and QR Code) for all transactions on hot storage mediums;
  2. Multisignature Wallets (requiring the entry of multiple private keys for substantial transactions in hot wallets);
  3. Setting concentration limits (i.e. no more than 5% of a particular cryptocurrency on a particular wallet) and dividing assets among multiple wallets;
  4. Depositing cold storage wallets in safety deposit boxes or physical vaults;
  5. Regularly replacing and properly destroying old electronic hardware;
  6. Having multiple backups and seeds to recover hardware and paper wallets; and
  7. Diversifying methods of hot and cold storage methods.

Based on the needs of a particular fund, the optimal storage approach is likely a combination of multiple methods of hot and cold storage, accompanied by a systematic application of some or all of the above-listed risk mitigation procedures.

Please feel free to reach out to us if you have any questions about cryptocurrency storage methods, or if you are thinking of starting a cryptocurrency fund.

Starting a Cryptocurrency Fund: Valuation Considerations

Written by Kevin Cott on . Posted in Digital Assets & Cryptocurrency Funds.

It is critical for fund managers and accounting professionals to have up-to-date valuations on investments when accepting capital contributions from new and existing investors. While valuation metrics for the broad majority of securities and futures products are well-developed, cryptocurrencies and other blockchain technologies present novel issues for Bitcoin and cryptocurrency fund managers when it comes to valuation. In this post, we will discuss valuation considerations for three activities: cryptocurrency trading, initial coin offerings (ICOs), and mining.

Cryptocurrency Trading

Valuation for large, well-known cryptocurrencies is relatively straightforward. Coinbase, Kraken and Poloniex are examples of U.S.-based exchanges that provide up-to-date prices on established cryptocurrencies. These exchanges can create reliable valuation metrics for the larger, more highly-traded cryptocurrencies such as Bitcoin, Etherum, and Litecoin. The aforementioned cryptocurrencies have 24-volume rates in excess of $100 million.

While not as reliable for the establishment of prices as the larger exchanges, the website https://coinmarketcap.com/currencies/ has up-to-date cryptocurrency prices and volume for almost every cryptocurrency available. Fund managers and accounting professionals should proceed cautiously, however, when it comes to the reliability of valuation of cryptocurrencies that have weak volume and/or are traded on smaller, foreign exchanges. At this time, we believe it is best to solely trade cryptocurrencies that are (i) available on established, U.S. exchanges and (ii) meet the fund or accounting professional’s internal volume requirements for reliable valuation.

ICOs

Investing in ICOs presents new challenges.  As we addressed in our previous post, it is likely that most tokens distributed in ICOs would be considered securities, subject to regulation by the Securities and Exchange Commission. We believe it is best practice for fund managers who intend to invest in ICOs to preemptively follow the applicable registration requirements imposed by the Investment Advisers Act of 1940 or applicable state securities regulator. In addition to regulatory considerations, the individual tokens distributed in an ICO can present challenging valuation issues.  We believe the best practice, at this time, is to side pocket ICO investments.

At the moment, the majority of companies conducting ICOs are doing so with an accompanying white paper that explains the details behind the token issuance. These white papers rarely, if ever, include audited financial statements and/or any obligation to continuously update financials in a manner that would allow a fund manager or accounting professional the ability to establish a reliable valuation for the investment. In addition, many of the ICOs (that are almost certainly securities) promise distributions of a percentage of profits of an unascertainable value as well as promises to buy back existing tokens in the future.

https://coinmarketcap.com/assets/views/all/ provides a compilation of previously ICO’d tokens, but very few tokens trade on reputable U.S. exchanges and/or have sufficient volume to establish reliable valuation. Similar to a traditional hedge fund investing in shares of a non-exchange-traded, emerging company, we believe it is the best practice to side pocket ICO’d tokens until the tokens are (i) listed on a reputable U.S. exchange with sufficient volume or (ii) bought back by the issuing company.

Mining

Mining is an integral part of many blockchain networks. Mining is the process of solving complex mathematical equations to add and verify transactions on a particular blockchain network in exchange for a reward of that particular blockchain network. Individuals and entities mine cryptocurrencies by running programs on their computers that utilize the available computing hardware to solve these mathematical processes. While it sounds simple enough, mining is not a cheap endeavor. Each miner competes with the other miners of the blockchain network to solve the mathematical equations in the fastest time possible. Therefore, more processing power means a higher likelihood of compensation. More processing power, however, also means exponentially higher associated expenses.

Mining expenses can be divided into two categories: upfront and operational costs.  The upfront costs involve the purchasing of multiple, high-powered graphical processing units (GPUs), a sufficient heat dissipation system, industrial electricity wiring, and a facility to store the equipment. The upfront costs of establishing a network that is of a sufficient scale to generate meaningful profits can be substantial—a small-scale commercial operation could potentially get started with around $250,000 in upfront expenses, while larger operations can easily top $1 million in upfront expenses.

Once the upfront costs of a mining operation are realized, the operation must factor in operational costs. This primarily consists of electricity costs associated with powering the hardware and cooling and ventilating the facility. These costs can be substantial and can cut into the profitability of cryptocurrency mining. One mid-range facility operated by The MegaBigPower Company estimated it spent approximately $1 million in electricity costs and upkeep expenses for a 20,000 square foot facility in 2014. For comparison, one of the world’s largest bitcoin mines, located outside of Beijing, spends $39,000 on electricity expenses each day ($14.2 million a year) to operate its 25,000 machines 24 hours a day. For comparison, there are multiple mining centers with square footage in excess of 100,000 sq. ft.

As a result, establishing a forward-looking valuation for an investment in a mining operation can be particularly challenging. For larger, more well-known cryptocurrencies, one can calculate estimated profits from mining activities based on the computing power and electricity costs associated with a mining operation. These estimates are of dubious value, however, and generally only available for the more established cryptocurrencies.

We believe there are three ways to handle valuation of mining operations:

First, the fairest and simplest method of valuing mining operations is to side pocket upfront and operational mining expenses, due to the difficulty, if not impossibility, of predicting the amount of profit the fund will generate per dollar spent on upfront mining expenses. Holding the upfront expenses (such as purchasing the building and hardware) at cost in the general fund could potentially provide a substantial windfall to subsequent investors in the fund by allowing the subsequent investors to receive profits from mining activities despite not actually contributing to the substantial upfront costs associated with getting a mining operation off the ground.

Another option is to side pocket the upfront expenses and share the maintenance costs among all interest holders in the fund. The upfront infrastructure purchases could be held at cost, while the valuation of mining activities in the general fund would increase or decrease based on revenue from mining operations minus expenses.  If a fund proceeded in this manner, the fund could divide profits from mining activities between side pocket investors and the general fund until the side pocket investors hit a certain ROI. This could reduce the windfall that subsequent investors would receive despite not contributing to the upfront expenses associate with establishing a mining operation.

The last method of valuation is for the fund to finance upfront costs into the general fund. This would dilute the ROI for investors who financed the significant upfront capital solely because the fund lacks the ability to establish a prospective valuation on mining. The best practice in this case would be to value the upfront expenses at cost or, in the more expensive alternative, retain a firm to provide a reasonable valuation metric (i.e. potential profit/dollar spent on infrastructure) in which the fund can rely on in establishing its AUM.

Final Thoughts

While cryptocurrencies and blockchain technologies have increased exponentially in popularity and utility, reliable methods of valuation still have a long way to go. We will continue to provide you with updates concerning new and existing methods of valuation of cryptocurrencies and blockchain assets. Please feel free to reach out to us if you have any questions regarding valuation of cryptocurrencies and blockchain assets, or if you are thinking of starting a cryptocurrency fund.

Cryptocurrency Fund Managers: SEC Update

Written by Kevin Cott on . Posted in Digital Assets & Cryptocurrency Funds, Regulatory & Compliance.

On Tuesday evening the SEC issued a significant report for cryptocurrency fund managers, announcing its determination that blockchain tokens offered and sold by an organization called The DAO were securities, subject to federal regulation. In its report, the SEC analyzed whether The DAO, Slock.it UG (a German corporation), Slock.it UG’s co-founders, and any intermediaries that brokered transactions violated federal securities laws through the issuance of DAO Tokens. Although the SEC ultimately elected not to bring charges or make specific findings regarding the transactions in connection with the issuance of DAO tokens, the SEC provided a cautionary report to all individuals and entities involved with future and past Initial Coin Offerings (ICOs), including cryptocurrency fund managers. Below is a brief background of the emergence of cryptocurrencies and ICOs, a securities analysis framework for ICOs moving forward, and finally our guidance regarding how certain virtual currency participants—particularly cryptocurrency fund managers—should proceed in light of the SEC’s report.

Understanding the terms

Blockchain: Blockchain is an emerging piece of technology that generally serves as a distributed electronic ledger—similar to a database of stored information—that is spread out and maintained by multiple individuals in a network of computers. Blockchain networks utilize cryptography and encryption methods to secure, process, and verify transactions that occur on the blockchain network. Virtual currencies (such as Bitcoin, Ethereum, and Litecoin) utilize blockchain technology to create and verify transactions that occur between users of the virtual currency.

Virtual Currencies (also labeled cryptocurrencies): Virtual currency is a digital representation of value that is issued and controlled by its developers, and used and accepted among the members of a specific (virtual) community. Unlike regular money, it is not issued by a central bank or other banking authority and is therefore called unregulated, decentralized and relying on a system of trust; this trust is typically accomplished through the use of cryptographic methods in blockchain technology. Many virtual currencies are convertible and can be exchanged to “real” money like the US Dollars.

Virtual Tokens or Coins: Virtual tokens or coins are typically units of value for virtual currencies. While virtual tokens or coins may represent other rights such as the right to utilize a product, virtual tokens or coins can often represent a financial interest in an entity or product; the latter potentially constituting a security.

Understanding the ICO

In an ICO, a company or other entity creates specialized virtual coins or tokens that it later distributes using blockchain technology. Individuals and entities that purchase these virtual coins or tokens typically exchange virtual currencies such as Bitcoin or Ether for the ICO company’s virtual coins or tokens. The capital raised in an ICO may go towards funding of a digital program, software, or other project. The virtual tokens or coins issued in an ICO can potentially be utilized by purchasers to access the digital platform, software, or contribute to the project in some capacity.

Where promoters and cryptocurrency fund managers may run afoul of federal securities laws is in situations where the ICO involves a return on investment or an interest in the company. For example, a startup company could potentially raise capital through an ICO; in lieu of issuing stock to investors, it could conduct an ICO and distribute virtual coins or tokens to investors, promising a share of future profits. Investors–including cryptocurrency fund managers–could then sell and purchase the virtual tokens or coins of the ICO for virtual currency or fiat currency (U.S. dollars) via virtual currency exchanges, thus creating a secondary market for the virtual coins or tokens of the ICO.

After the SECs release, the virtual coins or tokens that the company distributed would likely be considered securities subject to federal regulation. In addition, cryptocurrency fund managers purchasing such coins or tokens would need to comply with relevant Investment Adviser Act and Investment Company Act provisions and the virtual currency exchanges would likely be required to register as broker-dealers to avoid violation of federal securities laws.

Securities Analysis

In the SEC’s report, the SEC refrained from laying down concrete rules regarding whether any given ICO constitutes a securities offering. Instead, the Commission stated “[w]hether or not a particular transaction involves the offer and sale of a security— regardless of the terminology used—will depend on the facts and circumstances, including the economic realities of the transaction.” If the facts and circumstances of an ICO constitute the offer and sale of a security, the issuers and promoters of the ICO “must comply with the federal securities laws, including the requirement to register with the Commission or to qualify for an exemption from the registration requirements of the federal securities laws.”

While the facts and circumstances standard does not provide a concrete test, entities looking to conduct an ICO may utilize the securities analysis provided by Coinbase, the first regulated Bitcoin exchange in the United States, to obtain a preliminary understanding of whether a particular ICO may constitute the offer or sale of securities. Based on the Howey Test for whether an arrangement involves an investment contract, the securities analysis can be distilled to the following:

Blockchain tokens with one or more of the following rights are not likely to meet the definition of a security:

1. Rights to program, develop or create features for the system or to “mine” coins or tokens that are embedded in the system;
2. Rights to access or license the system;
3. Rights to charge a toll for such access or license;
4. Rights to contribute labor or effort to the system;
5. Rights to use the system and its outputs;
6. Rights to sell the products of the system; and
7. Rights to vote on additions to or deletions from the system in terms of features and functionality

Conversely, blockchain tokens that provide one or more of the following rights are likely to constitute a security:

1. Ownership interest in a legal entity, including a general partnership;
2. Equity interest;
3. Share of profits and/or losses, or assets and/or liabilities;
4. Status as a creditor or lender;
5. Claim in bankruptcy as equity interest holder or creditor;
6. Holder of a repayment obligation from the system or the legal entity issuer of the Blockchain Token; and
7. A feature allowing the holder to convert a non-security Blockchain Token into a Blockchain Token or instrument with one or more investment interests, or granting the holder an option to purchase one or more investment interests

Conclusions

While the SEC elected to not pursue charges against any individuals or entities that participated in The DAO ICO, this latest development signifies the SEC’s intent to assert its authority to regulate the digital asset and ICO market. Issuers intending on conducting an ICO and exchanges intending on brokering transactions involving virtual coins or tokens will need to consult qualified legal counsel prior to doing so. In addition, U.S. purchasers–including cryptocurrency fund managers–will need to consult qualified legal counsel concerning possible securities implications prior to doing so, including whether to register as an investment adviser and compliance with the Investment Company Act if planning on allocating investor funds toward ICOs and/or other virtual coin or token tractions.

We will continue to update you on further developments concerning blockchain networks, virtual currencies and ICOs. Given that the SEC has determined that an ICO’s status as a security will be decided on a case-by-case basis depending on the underlying facts and circumstances, we advise cryptocurrency fund managers to seek counsel before venturing into the virtual currency space. Please feel free to reach out to us if you have any additional questions about virtual currencies or the SEC’s report.