The early focus by the SEC and CFTC in the crypto asset space was primarily focused on preventing fraud and assessing risks to investors and the market. In cases not involving fraud, initial enforcement of digital asset investments were somewhat tempered, as regulators exercised a degree of forbearance to allow the budding industry to evolve. This period of early forbearance for digital asset market participants appears to be quickly coming to a close. Crypto asset hedge fund managers should not interpret past forbearance as an indication of current regulatory intent.
Thus far, the SEC has taken three enforcement actions against crypto asset hedge funds, primarily resulting from marketing the fund. The CFTC, which has taken a more accommodating stance toward digital assets, has nonetheless been active in enforcing violations, primarily focused on fraud, including at least one action against a crypto asset hedge fund manager. Additionally, beginning in 2018, crypto asset private litigation has risen sharply, and will likely result in a continuing trend of SEC and CFTC enforcement against crypto asset hedge funds.
Enforcement actions by the SEC in 2018 and 2019, as well as recent SEC statements, indicate that enforcement efforts have now shifted to encompass a broad range of violations extending to registration violations and technical compliance errors. In June 2019, the SEC filed a high-profile complaint against token issuer Kik Interactive, Inc. based not on deceptive misrepresentation, but on failure to register the token issuance as a securities offering. This enforcement trend has extended to hedge funds.
- Increase in Private Litigation
In addition to regulatory enforcement, there has been a significant increase in litigation against cryptocurrency market participants. Increased litigation will likely result in an increase in enforcement actions by the SEC. According to a report published by Lex Machina, securities litigation related to blockchain and cryptocurrency rose sharply during the first two quarters of 2018 as compared to 2017 filings. The total number of securities lawsuits referencing “blockchain,” “cryptocurrency” or “bitcoin” tripled in the first two quarters of 2018 compared to the previous year.
- CFTC Enforcement
In comparison to the SEC, the CFTC has taken a relatively light-handed approach towards the digital asset industry, although it has aggressively pursued fraud actions, including at least one enforcement action against a crypto asset hedge fund, discussed below. The CFTC has generally encouraged innovation in the digital asset space and several commissioners have made public comments encouraging engagement with the digital asset space to develop appropriate regulations.
In particular, the CFTC’s chairman, Christopher Giancarlo, who was affectionately nicknamed “crypto dad” by the digital asset community, focused heavily on understanding and engaging with the budding crypto asset industry. Christopher Giancarlo’s term concludes in July 2019, making the future regulatory stance potentially less certain. The new chairman, Heath Tarbert (currently serving as the acting Under Secretary of the US Treasury) is a Republican with an unknown stance on digital asset regulation.
Beginning in 2015, the CFTC has taken approximately twenty enforcement actions against various crypto asset market participants, including traders, issuers, exchanges, and service providers. In October 2018, the CFTC brought its first enforcement action against a crypto asset hedge fund, charging New York-based Gelfman Blueprint, Inc. (“GBI”) and its principal with fraudulent solicitation and false account statements. The Order for Final Judgement by Default and the Consent Order for Final Judgment found that GBI and its principal operated a Bitcoin Ponzi scheme in which they fraudulently solicited more than $600,000 from approximately 80 persons, supposedly for placement in a pooled commodity fund that purportedly employed a high-frequency, algorithmic trading strategy.
- SEC Enforcement
The SEC’s enforcement trend has extended to crypto asset hedge funds. In March 2018, the SEC began an ongoing probe of investment funds investing in digital asset funds, sending informational subpoenas to as many as 100 hedge funds investing in liquid crypto-asset instruments. These requests asked questions regarding various issues surrounding digital pricing, compliance practices, asset security methods, and other issues.
As of June 2019, the SEC has taken three enforcement actions against crypto asset hedge fund managers. Notably, all three actions were based, in part, on the fund manager’s failure to properly verify investor accreditation when engaging in advertising or general solicitation, as required for exemption under Rule 506(c) of Regulation D. Two of the three actions involved misrepresentations. In both cases, the misrepresentation appeared to be based on marketing activities, such as media interviews and disseminating information via websites, social media, and marketing material. This highlights the need for legal counsel’s involvement in reviewing marketing material and consulting on communications throughout the capital raise
Crypto Asset Management, LP and Timothy Enneking
In September 2018, the SEC took its first action against a crypto asset hedge fund, issuing an order against California based Crypto Asset Management, LP, and its sole principal. The misrepresentation and registration failures stemmed from the fund allegedly representing to investors in its marketing materials that the fund was registered with the SEC. Additionally, the fund did not limit its investors to those with whom it had a substantive relationship and engaged in various advertising and solicitation activities without satisfying the applicable exemption under Regulation D Rule 506(c), requiring an issuer to verify that an investor is accredited.
CoinAlpha Advisors LLC
In December 2018, the SEC filed an order against CoinAlpha Advisors, LLC, a California crypto asset hedge fund manager based on engaging in advertising and solicitation without verifying that each investor was accredited as required by Rule 506(c). During the investigation, the fund retained a third party to verify that each investor was accredited. However, to meet the exemption, it is not enough that the investors are accredited if verification procedures were not followed.
Mutual Coin Fund LLC and Usman Majeed
In April 2019, the SEC filed an order against a Michigan-based crypto asset fund and its sole manager for misrepresentation and failure to register or satisfy an appropriate exemption. According to the order, the manager misrepresented the amount of capital raised and the size of other investors’ actual and prospective investments. Additionally, the fund failed to properly satisfy a registration exemption by allegedly engaging in advertising through its website and media interviews, failing to satisfy Rule 506(c).
- Key Areas of Liability
Whether from regulatory enforcement or private litigation, liability typically arises in two key areas: (i) failure to register or satisfy an appropriate exemption; and (ii) misrepresentations or omissions. Both of these areas of liability are closely tied to the marketing efforts of the fund manager.
i. Failure to Register or Satisfy Exemptions
For digital asset funds investing in securities, this includes obtaining appropriate exemptions from registration under the Securities Act of 1933 (Securities Act), the Investment Company Act of 1940 and either registering or satisfying an appropriate exemption under the Investment Advisers Act of 1940 or as applicable, registration with the CFTC under the Investment Advisers Act. See our blog post, “Must a Hedge Fund Register as an Investment Advisor?,” for more information.
A common way that an emerging hedge fund manager can lose its exempt status is by improperly engaging in advertising and general solicitation when marketing the fund, in contravention of Regulation D Rule 506(c) of the Securities Act. Advertising and general solicitation can include disseminating information on the manager’s website, social media, live or recorded presentations, media interviews, and otherwise contacting potential investors with whom the manager does not have a substantive preexisting business or personal relationship.
Securities issuers that raise capital via advertising and general solicitation must follow the strict requirements of Regulation D, which includes the requirement to take reasonable steps to verify that each investor is accredited. Verification can be accomplished by direct inspection of an investor’s tax or financial records or more commonly, through certification of the investor’s accreditation status by a licensed CPA, broker-dealer, or attorney after reviewing the investor’s records.
ii. Misrepresentations or Omissions
Various laws against misrepresentations or omissions of material information are administered by the SEC, the states, and the CFTC, and can be applied broadly. Liability for misrepresentation can arise not only in the offering documents but in marketing materials, email communication or verbal statements. For managers of pooled investment vehicles, misrepresentation standards under the Investment Advisers Act are especially strict and can give rise to liability for unintentional misrepresentation under a standard of negligence. Disclosure standards should be strictly adhered to and all communication with current and prospective investors should be carefully reviewed on an ongoing basis both internally and by legal counsel.