Originally published in Nasdaq.com.

NFT’s (Non-fungible tokens) are in vogue, and they are what’s trending in the crypto economy. While it is a fairly new phenomenon, they continue to increase in popularity. With that, a new crop of investors have entered a world that has, for the most part, been viewed as untouchable and esoteric.

For a manager without previous fund management experience or ready access to initial investor capital, an incubator fund provides a cost effective way to begin building a marketable performance record using the manager’s personal funds.  An incubator fund allows a manager to fine-tune the trading strategy while creating a marketable track record.

In the ever-evolving and developing age of virtual currencies, fund managers of digital asset-focused funds have the additional challenge of not just trying to keep up with securities regulations on the state and federal levels, but proactively anticipating new regulations, through the guidance of their legal counsel, in order to maintain their fund’s compliance long-term. Investors in Bitcoin and other forms of digital assets find themselves at the distinct disadvantage of having to navigate through a convoluted set of rules, adding to the already complex process of fund formation and investment management.

We ask hedge fund managers five main questions to determine who can invest in their fund. Many prospective fund managers mistakenly believe that the “accredited investor” standard is the only required investor accreditation standard for their investors. 

As part of the hedge fund formation process, the attorney works closely with the fund sponsor to craft the terms to which the fund and its investors will be bound. When properly structured, hedge fund offering documents contain terms that adequately protect the fund sponsor and are attractive to investors. Hedge fund terms are driven by a combination of the market trends and investor appetite within the fund’s specific asset class and the particular needs and objectives of the fund.

The following is a brief survey of categories of some of the most common hedge fund terms.

A Private Placement Memorandum (“PPM”), also known as a private offering document and confidential offering memorandum, is a securities disclosure document used in a private offering of securities by a private placement issuer or an investment fund (collectively, the “Issuer”). From an investor’s point of view, the purpose of the PPM is to obtain needed information about the Issuer and its securities, both good and bad, to make an informed decision about whether to purchase the security. The investor wants to know the parameters of investing in the Issuer and the potential rights, risks, and rewards of its investment. For the Issuer, the purpose of the PPM is to provide the necessary disclosures about the risks, strategies, management team, investment criteria, and other information about its securities to protect itself and its managers against claims of misstatements or omissions.

Your legal counsel will prepare six core documents, which are necessary to launch the fund: (i) a private placement memorandum, (ii) a limited partnership agreement, (iii) a subscription agreement, (iv) an investment management agreement, (v) a general partner operating agreement, and (vi) a management company operating agreement.

Other services and documents that are also generally completed include the formation services of the limited partnership, the management company, and the general partner; drafting the management company operating agreement; preparing and filing the Edgar registration; drafting and filing state and federal Form D notice filings; and as necessary, preparing and filing any state or federal registrations or exemptions (or other necessary fund formation documentation).

In June of 2019 we presented the Global Regulation of Digital Asset Funds, in partnership with Harneys, a leading Cayman law firm, with which we have worked extensively in structuring global digital asset funds.  Our June symposium featured a panel of leading authorities on various aspects of global digital asset regulation, including securities law, taxation, and anti-money-laundering compliance.

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.  

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.