Digital asset fund managers face substantial risk in the disclosure of their investment fund strategy and have limited precedent in preparing those disclosures. As an emerging asset concept, distributed ledger technology presents a myriad of potential regulatory considerations, technological complexities, and market uncertainties with few analogous instruments. As with any fund offering disclosure, digital asset fund managers are advised to err on the side of thoroughness and caution in disclosing the breadth of the investment strategy and its potential risks.
Investment into digital assets facilitates anonymity and has the potential to be used by investors to mask various illegal transactions, including money laundering, funding of terrorist activities, and numerous regulatory violations. In addition to the AML procedures that token issuers and various intermediaries must perform, hedge funds must carefully comply with AML regulations when accepting crypto tokens from investors in lieu of fiat capital as an in-kind contribution.
The regulation of cryptocurrency fund managers is heavily dependent on how crypto digital assets are classified. In early analysis, US government regulatory bodies often categorized digital assets differently. Below is a brief overview of the various asset classifications by the SEC, the CFTC, the IRS, and Fincen, which are the US regulators most critical in governing the activities of crypto asset hedge fund managers. Note that US regulation of crypto-asset funds is in a state of flux, with a litany of regulatory issues that have yet to be resolved, and which may change over time.
In the short period from 2014 through 2019, hedge fund management and strategy has varied significantly in response to market forces. Following the significant surge of cryptocurrency funds in 2017 and 2018, there has been a noticeable trend toward increased sophistication of participating fund managers and investors.
Of the several hundred digital asset funds with managers or investors domiciled within the United States, only a minuscule portion have become fully registered investment advisers with the SEC. Instead, most of these digital asset funds have thus far avoided SEC adviser registration in one of three ways:
US Regulation of hedge funds—including digital asset funds—is conducted at two levels: (i) the issuer-level and (ii) the adviser-level. At the issuer level, the SEC and individual states regulate investment into the fund by US fund investors. At the adviser level, managers are regulated by either the SEC, CFTC, or neither based on whether the portfolio assets are classified as securities or commodities.
The structure of crypto-asset investment funds are driven by investment strategy goals, regulatory requirements, and tax considerations. The fund’s entity structure and allocation provisions aim to create efficiencies for fund managers and investors alike. For digital asset funds anticipating only US taxpayers, the fund vehicle is generally structured as a pass-through vehicle taxed as a partnership, either as a limited partnership or a limited liability company. However, as noted below, some crypto asset funds elect to trade through an offshore master-feeder or mini-master structure, regardless of whether the fund anticipates offshore investors.
The CFTC treats certain digital assets as commodities, including virtual payment tokens, utility tokens, and others under Section 1a(9) of the Commodities Act of 1936. CFTC regulated assets interests include: futures contracts, options on futures contracts, and swaps, including foreign exchange transactions. The CFTC has taken the position that virtual payment tokens, such as Bitcoin, are not considered currency because it is not accepted as legal tender in any jurisdiction.
On December 14, 2018, in anticipation of the IRS hearing for the Qualified Opportunity Zone (the “QOZ”) legislation, our firm hosted the Opportunity Zone Real Estate Fund Workshop at Columbia University’s Faculty House.
One of the initial considerations when structuring a hedge fund is whether to form the fund domestically, offshore or both. If a fund sponsor expects to have only U.S. investors, a domestic entity is sufficient. However, if a sponsor anticipates offshore investors or U.S. tax-exempt investors (IRAs, pension plans, endowments, etc.) an appropriate offshore fund will be needed to shield such investors from U.S. tax liability.
This article provides an overview of CFTC and SEC regulation of cryptocurrency hedge funds for hedge fund managers investing in various strategies involving Bitcoin and alternative cryptocurrencies.
Our law firm focuses on advising hedge fund managers throughout the world in starting and operating US and offshore hedge funds. During the past several months, we have received more inquiries for starting cryptocurrency hedge funds (including Bitcoin Funds and coin alternative funds) than for all other hedge fund strategies combined.
Operating a hedge fund entails significant legal exposure, with substantial liability for improper disclosure. Even inadvertent mistakes can lead to substantial personal liability. The SEC, the CFTC, the NFA and state securities regulators have developed complex regulatory frameworks with which a fund sponsor must comply to avoid liability.
New York is the world’s most popular jurisdiction for starting a hedge fund, as well as one of the top states for startup private equity funds, real estate funds and other alternative investment funds. Fund managers starting a hedge fund in New York avail themselves of a well-paved regulatory structure that is benefited by regulatory bodies with decades of experience with hedge funds and other investment funds.
The process for starting a hedge fund involves much more than a hedge fund attorney drafting the disclosure documents and preparing regulatory filings. Drafting the documents is only one component of a comprehensive fund formation process. A common mistake we see is hedge funds that are prepared using a form-driven approach, which results in investment fund terms and structure that are based on a generic structure, or often the wrong structure entirely. A template-based approach results in fund terms and structure that are not in line with the specific fund's needs, market position and regulatory structure.
Dodd-Frank exempts from registration two types of advisers: (i) advisers to qualifying venture capital funds; and (ii) advisers solely to private funds (including hedge funds and private equity funds) and having less than $150 million of assets under management. These two categories of investors are known as exempt reporting advisers. Certain exempt reporting advisers are required to file exempt reporting adviser registrations, as will be discussed below.