Laura Anthony

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    • Title:Founding Partner
    • Organization:Legal & Compliance, LLC
    • Area of Expertise:Securities Law
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    The SEC Has Provided Guidance On Ether and Bitcoin, Sort Of

    Tuesday, June 19, 2018, 8:23 AM [General]
    0 (0 Ratings)

    On June 14, 2018, William Hinman, the Director of the SEC Division of Corporation Finance, gave a speech at Yahoo Finance’s All Markets Summit in which he made two huge revelations for the crypto marketplace. The first is that he believes a cryptocurrency issued in a securities offering could later be purchased and sold in transactions not subject to the securities laws. The second is that Ether and Bitcoin are not currently securities. Also, for the first time, Hinman gives the marketplace guidance on how to structure a token or coin such that it might not be a security.

    While this gives the marketplace much-needed guidance on the topic, a speech by an executive with the SEC has no legal force. As a result, the blogs and press responding to Mr. Hinman’s speech have been mixed. Personally, I think it is a significant advancement in the regulatory uncertainty surrounding the crypto space and a signal that more constructive guidance will soon follow. I will summarize the entire speech later in this blog, but first right to the most salient point.

    Although a speech by an SEC official does not have legal weight, it does give practitioners a firm foot on which to proceed. William Hinman is the Director of the Division of Corporation Finance (“CorpFin”), whose responsibility includes reviewing and commenting on SEC filings, a topic I’ve written about before. As described in my recent blog on the subject (see HERE), when responding to SEC comments, a company may also “go up the ladder,” so to speak, in its discussion with the CorpFin review staff. Such further discussions are not discouraged or seen as an adversarial attack in any way. For instance, if the company does not understand or agree with a comment, it may first talk to the reviewer. If that does not resolve the question, they may then ask to talk to the particular person who prepared the comment or directly with the legal branch chief or accounting branch chief identified in the letter. A company may even then proceed to speak directly with the assistant director, deputy director, and then even director.

    Related to Bitcoin, Director Hinman stated, “…when I look at Bitcoin today, I do not see a central third party whose efforts are a key determining factor in the enterprise. The network on which Bitcoin functions is operational and appears to have been decentralized for some time, perhaps from inception. Applying the disclosure regime of the federal securities laws to the offer and resale of Bitcoin would seem to add little value.” Similarly, related to Ether, Mr. Hinman stated, “…putting aside the fundraising that accompanied the creation of Ether, based on my understanding of the present state of Ether, the Ethereum network and its decentralized structure, current offers and sales of Ether are not securities transactions.”

    As a direct result of these statements, at least 2 of our clients, with our support, have shifted how they will proceed with Regulation A offerings in which tokens are being offered, and Bitcoin and Ether expected to be excepted as a form of payment. Prior to Mr. Hinman’s comments, CorpFin issued comments to our clients, which comment letters gave an indication of the progression of the SEC’s thinking. In particular, in an earlier letter the SEC comment was in relevant part as follows:

    We note that you will accept Bitcoin, Ether, Litecoin or Bitcoin Cash as payment for your common stock. Please disclose the mechanics of the transaction. For example, explain the following:

    • whether the digital assets are securities and, where you have determined they are, how you will structure each individual transaction so that you are in compliance with the federal securities laws;
    • disclose how long the company would typically hold these digital assets, some of which may be securities, before converting to U.S. dollars;
    • include risk factor disclosure discussing the impact of holding such assets and/or accepting this form of payment, including price volatility and liquidity risks as well as risks related to the fragmentation, potential for manipulation, and general lack of regulation underlying these digital asset markets; and
    • disclose how you will hold the digital assets that you may receive in this offering as payment in exchange for shares of your common stock. If you intend to act as custodian of these digital assets, some of which may be securities, please tell us whether you intend to register as a custodian with state or federal regulators and the nature of the registration.

    The comment letter included many other points on cybersecurity, price volatility, risk factors and other issues not related to whether the Bitcoin or Ether were a security. In a recent comment letter for a different client, also offering tokens in a Regulation A offering and accepting Bitcoin and Ether as payment, the SEC did not issue any questions as to whether Bitcoin or Ether were a security, but did include substantially the same questions related to cybersecurity, price volatility, risk factors and other business points.

    The SEC CorpFin is pragmatic in its approach and despite frustrations at times, would not allow its Division Director to make public statements and then allow its staff to issue comments or take positions that were in direct contravention to those statements. Keep in mind that SEC no-action letters technically do not set precedence or have any legal bearing outside of the parties to the letter, but are regularly relied upon by the SEC and practitioners for guidance.

    Although Mr. Hinman’s speech does not have legal authority, I am confident that the SEC will not raise the issue or question whether Bitcoin or Ether are a security in current and future registration statements or Regulation A offerings, at least until there is different legal authority than exists today.… And, there could be different legal authority in the future. I attended a Regulation A conference in New York in the beginning of June, and one of the panels was related to cyrptocurrencies. In addition to attorneys in the space, the panel included Anita Bandy, Assistant Director of the SEC Division of Enforcement.  Referring to token or coin offerings, one of the panel members specifically stated that Ether is a security and Ms. Bandy did not correct him. Furthermore, at the end of the panel, I privately asked Ms. Bandy if it is her opinion that Ether is a security today. She politely refused to answer the question, letting me know that she couldn’t express an opinion on that without conferring with other SEC management.  Two days later, Mr. Hinman gave his speech.

    …. But, Mr. Hinman is Director of CorpFin and Ms. Bandy is part of the Division of Enforcement.  Although I believe that the SEC divisions are communicating with each other on the very relevant and important subject of cryptocurrency, and have even issued joint statements on the subject, they are separate. Moreover, decoding Mr. Hinman’s statements further, he said, “… putting aside the fundraising that accompanied the creation of Ether…” This begs the question: What would happen if the SEC Division of Enforcement took action related to the initial fundraising and creation of Ether, and how would that impact the current status of Ether? My thought is that they are mutually exclusive.  Ether is decentralized today and will continue its own course.

    The SEC Division of Enforcement could take action similar to the Munchee, Inc. case where it settled the proceeding with no civil penalty. The SEC could also issue another report on Ether similar to the Section 21(a) Report on the DAO issued a year ago in July 2017, though I don’t know what new or different information it could add to that analysis. If Ether violated the federal securities laws at its issuance, it did so in the same way as the DAO, using the SEC v. W. J. Howey Co. test. Perhaps a new report could provide more guidance as to the analysis of when a crypto reaches a point where it is decentralized enough such that it no longer meets the parameters laid out in Howey, or that might be wishful thinking on my part.

    Director Hinman’s Speech “Digital Asset Transactions: When Howey Met Gary (Plastic)”

    Director Hinman opens his speech with the gating question of whether a digital asset that is offered and sold as a security can, over time, become something other than a security. He then continues that in cases where the digital asset gives the holder a financial interest in an enterprise, it would remain a security.  However, in cases where the enterprise becomes decentralized or the digital asset can only be used to purchase goods or services available through a network, the purchase and sale of the digital asset would no longer have to comply with the securities laws.

    Reiterating the oft-repeated view of the SEC, Hinman notes that most initial coin or token offerings are substantially similar to debt or equity offerings in that they are just another way to raise money for a business or enterprise. In particular, funds are raised with the expectation that the network or system will be built and investors will get a return on their investment. The investment is often made for the purpose of the return and not by individuals that would ever use the eventual utility of the token. The return is often through the resale of the tokens or coins in a secondary market on cryptocurrency trading platforms.

    In this case, the Howey Test is easy to apply to the initial investment. The Howey Test requires an investment of money in a common enterprise with an expectation of profit derived from the efforts of others. The emphasis is not on the thing being sold but the manner in which it is sold and the expectation of a return.  Certainly, the thing being sold is not a security on its face; it is simply computer code.  But the way it is sold – as part of an investment, to non-users, by promoters to develop the enterprise – can be, and in that context most often is, a security. Furthermore, in the case of ICOs, which are high-risk by nature, the disclosure requirements of the federal securities laws are fulfilling their purpose.

    The securities laws apply to both the issuance or initial sale, and the resale of securities. In the case of coins or tokens, a careful analysis must be completed to determine if the resale of the coin or token also involves the sale of a security and compliance with the securities laws. If the network on which the token or coin is to function is sufficiently decentralized such that purchasers would not reasonably expect a person or group to carry out essential managerial or entrepreneurial efforts, the assets may no longer represent an investment contract. Moreover, when the efforts of the third party are no longer a key factor for determining the enterprise’s success, material information asymmetries recede. As a network becomes truly decentralized, the ability to identify an issuer or promoter to make the requisite disclosures becomes difficult, and less meaningful, such as with Ether and Bitcoin as discussed above.

    An analysis as to whether an investment contract and therefore a security is being sold must be made based on facts and circumstances at any given time.  Investment contracts can be made out of virtually any asset if it is packaged and promoted as such. Accordingly, although Bitcoin or Ether may not be a security on their own, if they were packaged as part of a fund or trust, they could be part of an investment contract that would need to comply with the federal securities laws.

    Hinman provides some guidance in determining whether a particular sale involves the sale of an investment contract. The primary consideration is whether a third party, such as a person, entity, or coordinated group, drives the expectation of a return on investment. Questions to consider include:

    1. Is there a person or group that has sponsored or promoted the creation and sale of the digital asset, the efforts of whom play a significant role in the development and maintenance of the asset and its potential increase in value?
    2. Has this person or group retained a stake or other interest in the digital asset such that it would be motivated to expend efforts to cause an increase in value in the digital asset? Would purchasers reasonably believe such efforts will be undertaken and may result in a return on their investment in the digital asset?
    3. Has the promoter raised an amount of funds in excess of what may be needed to establish a functional network, and, if so, has it indicated how those funds may be used to support the value of the tokens or to increase the value of the enterprise? Does the promoter continue to expend funds from proceeds or operations to enhance the functionality and/or value of the system within which the tokens operate?
    4. Are purchasers “investing,” i.e., seeking a return? In that regard, is the instrument marketed and sold to the general public instead of to potential users of the network for a price that reasonably correlates with the market value of the good or service in the network?
    5. Does application of the Securities Act protections make sense? Is there a person or entity others are relying on that plays a key role in the profit-making of the enterprise such that disclosure of their activities and plans would be important to investors? Do informational asymmetries exist between the promoters and potential purchasers/investors in the digital asset?
    6. Do persons or entities other than the promoter exercise governance rights or meaningful influence?

    Hinman then, for the first time, gives some guidance to issuers and their counsel in determining whether a particular token or coin is being structured as a security. Hinman is clear that this list of factors is not comprehensive but rather lays the groundwork for a thoughtful analysis.  Items to consider include:

    1. Is token creation commensurate with meeting the needs of users or, rather, with feeding speculation?
    2. Are independent actors setting the price or is the promoter supporting the secondary market for the asset or otherwise influencing trading?
    3. Is it clear that the primary motivation for purchasing the digital asset is for personal use or consumption, as compared to investment? Have purchasers made representations as to their consumptive, as opposed to their investment, intent? Are the tokens available in increments that correlate with a consumptive versus investment intent?
    4. Are the tokens distributed in ways to meet users’ needs? For example, can the tokens be held or transferred only in amounts that correspond to a purchaser’s expected use? Are there built-in incentives that compel using the tokens promptly on the network, such as having the tokens degrade in value over time, or can the tokens be held for extended periods for investment?
    5. Is the asset marketed and distributed to potential users or the general public?
    6. Are the assets dispersed across a diverse user base or concentrated in the hands of a few that can exert influence over the application?
    7. Is the application fully functioning or in early stages of development?

    In another step towards regulatory guidance, Hinman said the SEC is prepared to provide more formal interpretive or no-action guidance about the proper characterization of a digital asset in a proposed use. As recently as 3 months ago, the SEC had indicated it was not processing no-action letters on the subject at that time. In his speech, Hinman recognizes the implication of determining something is a security, including related to broker-dealer licensing, exchange registration, fund registration, investment advisor registration requirements, custody and valuation issues.

    Hinman also expressed excitement about the potential surrounding digital ledger technology, including advancements in supply chain management, intellectual property rights licensing, and stock ownership transfers. He thinks the craze behind ICOs has passed, and I agree. In particular, as he states, realizing that securities laws apply to an ICO that funds development, industry participants have started to revert back to traditional debt or equity offerings and only selling a token once the network has been established, and then only to those that need the functionality of the network and not as an investment.

    There have been earlier signs that the SEC is softening and rethinking its approach to cryptocurrencies as well.   In a speech to the Medici Conference in Los Angeles on May 2, 2018, SEC Commissioner Hester M. Peirce warned against regulators stifling the innovation of blockchain by trying to label token and coins as securities and even when they are securities, being myopic on the need to fit within existing securities laws and regulations.  Like Director Hinman, Commissioner Peirce encourages communication between market participants and the SEC as everyone tries to navigate the marketplace and technology.

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    The 2017 SEC Government-Business Forum On Small Business Capital Formation Final Report

    Tuesday, June 12, 2018, 8:45 AM [General]
    0 (0 Ratings)

    The SEC has published the final report and recommendations of the 2017 annual Government-Business Forum on Small Business Capital Formation (the “Forum”). As required by the Small Business Investment Incentive Act of 1980, each year the SEC holds a forum focused on small business capital formation.  The goal of the forum is to develop recommendations for government and private action to eliminate or reduce impediments to small business capital formation.  I previously summarized the opening remarks of the SEC Commissioners. See HERE.

    The forum is taken seriously by the SEC and its participants, including the NASAA, and leading small business and professional organizations.  Recommendations often gain traction. For example, the forum first recommended reducing the Rule 144 holding period for Exchange Act reporting companies to six months, a rule which was passed in 2008. In 2015 the forum recommended increasing the financial thresholds for the smaller reporting company definition, and the SEC did indeed propose a change following that recommendation. See my blog HERE for more information on the proposed change. Also in 2015 the forum recommended changes to Rules 147 and 504, which recommendations were considered in the SEC’s rule changes that followed.  See my blog HERE for information on the new Rule 147A and Rule 147 and 504 changes.

    The 2017 Forum had two breakout groups which discussed exempt securities offerings, including micro offerings and smaller registered and Regulation A offerings.  Many of the recommendations relate to Regulation A. I recently wrote an update on Regulation A, including many suggestions recommended by the Forum.  For a complete review of Regulation A and suggested changes, see HERE.

    Forum Recommendations

    The following is a list of the recommendations listed in order or priority. The priority was determined by a poll of all participants and is intended to provide guidance to the SEC as to the importance and urgency assigned to each recommendation. I have included my comments and commentary with the recommendations.

    1. The first recommendation was also the first recommendation last year. As recommended by the SEC Advisory Committee on Small and Emerging Companies, the SEC should (a) maintain the monetary thresholds for accredited investors; and (b) expand the categories of qualification for accredited investor status based on various types of sophistication, such as education, experience or training, including, but not limited to, persons with FINRA licenses, CPA or CFA designations, or management positions with issuers. My blog on the Advisory Committee on Small and Emerging Companies’ recommendations can be read HERE. Also, to read on the SEC’s report on the accredited investor definition, see HERE.
    2. The SEC should issue guidance for broker-dealers, transfer agents and clearing firms regarding Regulation A issued securities and OTC securities. Moreover, the SEC should revise Regulation A to: (i) mandate blue sky preemption for secondary trading of Regulation A Tier 2 securities; (ii) allow at-the-market offerings; (iii) allow all reporting companies to use Regulation A; (iv) increase the maximum offering amount in any twelve-month period from $50 million to $75 million for Tier 2 offerings; (v) consider overriding any state advance notice requirements and putting a limit on state filing fees; (vi) require portals conducting Regulation A offerings to be registered similar to funding portals under Regulation Crowdfunding and require the portals to make disclosures, including those related to compensation.
    3. The SEC should lead a joint effort with FINRA to provide clear guidance for Regulation Crowdfunding offerings.
    4. Related to Regulation Crowdfunding, the SEC should: (i) remove the cap for investments by accredited investors; (ii) raise the investment cap for non-accredited investors by making the limit applicable to each investment instead of the aggregate; (iii) rationalize the investment cap by entity type, not income; (iv) allow portals to receive compensation on different terms such as warrants, and allow portals to co-invest in offerings; (v) amend the rules for small debt offerings to limit the ongoing reporting requirements to only the note holders and to scale the regulatory obligations to reduce the legal, accounting and other costs of the offering; (vi) increase the offering limit to $5 million in any twelve-month period; (vii) allow the use of special purpose vehicles (SPVs); and (viii) allow testing the waters before a filing.
    5. Small intermittent finders should be exempt from broker-dealer registration. See HERE.
    6. The SEC should clarify the relationship between exempt offerings that allow general solicitation (506(c)) and those that do not (506(b)) by: (i) applying the facts and circumstances analysis as to whether a particular investor was brought into an offering as a result of general solicitation (thus avoiding the necessity to verify accredited status); and (ii) apply Rule 152 to a Rule 506(c) offering to avoid integration with a follow-on registered offering. I note, however, that I believe Rule 152 already applies or if it does not, that a subsequent registered offering is not otherwise prohibited.
    7. Permit an alternative trading system, such as OTC Markets, to file a Form 211 application with FINRA and review the FINRA process to reduce the Form 211 application process burdens. See HERE.
    8. Amend the definition of smaller reporting company and non-accelerated filer to include a company with a public float of less than $250 million or with annual revenues of less than $100 million.
    9. Related to venture exchanges, Congress and the SEC should look to existing alternative venture exchanges (OTC Markets) and work within the existing framework. See HERE.
    10. The SEC should mandate additional disclosure on short positions and enforce Regulation SHO and Regulation T for all IPOs.
    11. Proxy advisory firms should be brought under SEC registration so that the SEC may oversee how these firms make recommendations and mitigate conflicts of interest.
    12. Withdraw the proposed rule changes to Regulation D, Form D and Rule 156. See HERE.
    13. The SEC should lead a joint effort with NASAA and FINRA to implement the private placement broker-dealer as recommended by the American Bar Association. See HERE.
    14. The SEC should allow a quick response (QR) code to suffice for delivery prospectus requirements after effectiveness of a registration statement or qualification of an offering circular.
    15. Study and propose a revised regulatory regime for true peer-to-peer lending platforms for small businesses and consumers, using current European regulatory and other models as reference.
    16. The SEC should expand disclosure requirements for stock promotion activity, including updating Section 17(b) to require better disclosures when a company is engaging promotional and investor relations firms.
    17. The SEC should amend unlisted trading privileges rules to allow small and medium-size public companies the option to consolidate secondary trading to one or more trading platforms.
    18. The SEC should allow for flexibility in tick sizes and consider making the pilot program permanent. See HERE.
    19. The SEC should provide greater clarity with respect to which courts and authorized governmental entities may act to satisfy the exemption from registration for exchange transactions under Securities Act Section 3(a)(10), and communicate the same to broker-dealers...

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    Online Platforms Trading Cryptocurrencies; Continued Uncertainty In Crypto Space

    Tuesday, June 5, 2018, 7:55 AM [General]
    0 (0 Ratings)

    I have been writing often about the cryptocurrency marketplace and the SEC and other regulators’ statements and concerns about compliance with the federal securities laws. On July 25, 2017, the SEC issued a Section 21(a) Report on an investigation related to an initial coin offering (ICO) by the DAO, concluding that the ICO was a securities offering.  In that Report the SEC stated that securities exchanges providing for trading must register unless an exemption applies. In its numerous statements on cryptocurrencies since then, the SEC has consistently reminded the public that exchanges that trade securities, including cryptocurrencies that are securities, must be licensed by the SEC.

    The SEC has also stated that as of today, no such licensed securities cryptocurrency exchange exists. However, a few CFTC regulated exchanges have now listed bitcoin futures products and, in doing so, engaged in lengthy conversations with the CFTC, ultimately agreeing to implement risk mitigation and oversight measures, heightened margin requirements, and added information sharing agreements with the underlying bitcoin trading platforms.

    The topic of the registration of exchanges for trading cryptocurrencies is not new to regulators. Years before the Section 21(a) DAO Report and crypto craze, on December 8, 2014, the SEC settled charges against BTC Virtual Stock Exchange and LTC-Global Virtual Stock Exchange, which traded securities using virtual currencies, bitcoin or litecoin. According to the SEC release on the matter, “the exchanges provided account holders the ability to use bitcoin or litecoin to buy, sell, and trade securities of businesses (primarily virtual currency-related entities) listed on the exchanges’ websites. The venues weren’t registered as broker-dealers despite soliciting the public to open accounts and trade securities. The venues weren’t registered as stock exchanges despite enlisting issuers to offer securities for the public to buy and sell.” The exchanges charged and collected transaction-based compensation for each executed trade on the platforms.

    Since the Section 21(a) DAO Report, most of the statements from the SEC and other regulators have focused on ICOs and the issuance of cryptocurrencies as opposed to focusing on the exchanges that trade cryptos. On March 7, 2018, the SEC finally issued a public statement directed specifically to online platforms for the trading of digital assets – i.e., cryptocurrencies. This blog will summarize that statement. Also, at the end of this blog is a list with links to my numerous other blogs on the topic of distributed ledger technology (blockchain), cryptocurrencies and ICOs.

    SEC Statement on Potentially Unlawful Online Platforms for Trading Digital Assets

    Online trading platforms have become prevalent for the buying and selling of coins and tokens, including new cryptocurrencies offered in initial coin offerings (ICOs). Many platforms bring buyers and sellers together in one place and offer investors access to automated systems that display priced orders, execute trades, and provide transaction data. If a platform offers trading of digital assets that are securities and operates as an “exchange,” as defined by the federal securities laws, then the platform must register with the SEC as a national securities exchange or be exempt from registration.  As mentioned above, no such SEC-registered platform exists as of today.

    In its statement, the SEC cautions investors that “[T]o get the protections offered by the federal securities laws and SEC oversight when trading digital assets that are securities, investors should use a platform or entity registered with the SEC, such as a national securities exchange, alternative trading system (‘ATS’), or broker-dealer.”

    The SEC is concerned that online platforms have the appearance of regular licensed securities exchanges, including using the word “exchange” when they are not. The SEC does not review the standards these “exchanges” use to pick or vet digital assets and cryptocurrencies, the trading protocols used to determine how orders interact and are executed, nor any internal controls or procedures of these platforms. Furthermore, the SEC warns that data provided by these trading platforms, such as bid and ask prices and execution information, may lack integrity.

    The SEC provides a list of questions for investors to ask when considering trading on an online platform, including:

    • Do you trade securities on this platform? If so, is the platform registered as a national securities exchange (see our link to the list below)?
    • Does the platform operate as an ATS? If so, is the ATS registered as a broker-dealer and has it filed a Form ATS with the SEC (see our link to the list below)?
    • Is there information in FINRA’s BrokerCheck ® about any individuals or firms operating the platform?
    • How does the platform select digital assets for trading?
    • Who can trade on the platform?
    • What are the trading protocols?
    • How are prices set on the platform?
    • Are platform users treated equally?
    • What are the platform’s fees?
    • How does the platform safeguard users’ trading and personally identifying information?
    • What are the platform’s protections against cybersecurity threats, such as hacking or intrusions?
    • What other services does the platform provide? Is the platform registered with the SEC for these services?
    • Does the platform hold users’ assets? If so, how are these assets safeguarded?

    Registration or Exemption of an Exchange

    Section 5 of the Exchange Act of 1934, as amended (“Exchange Act”) makes it unlawful for any broker, dealer, or exchange, directly or indirectly, to effect any transaction in a security, or to report any such transaction, in interstate commerce, unless the exchange is registered as a national securities exchange or is exempted from such registration. A national securities exchange registers with the SEC under Section 6 of the Exchange Act.

    Section 3(a)(1) of the Exchange Act defines an “exchange” as “any organization, association, or group of persons, whether incorporated or unincorporated, which constitutes, maintains, or provides a market place or facilities for bringing together purchasers and sellers of securities or for otherwise performing with respect to securities the functions commonly performed by a stock exchange as that term is generally understood….” Exchange Act Rule 3b-16 further defines an exchange to mean “an organization, association, or group of persons that: (1) brings together the orders for securities of multiple buyers and sellers; and (2) uses established, non-discretionary methods (whether by providing a trading facility or by setting rules) under which such orders interact with each other, and the buyers and sellers entering such orders agree to the terms of the trade.” The SEC has also stated that “an exchange or contract market would be required to register under Section 5 of the Exchange Act if it provides direct electronic access to persons located in the U.S.”

    According to the SEC website, as of today there are 21 licensed exchanges registered with the SEC. Exchanges that trade securities futures are registered with the SEC through a notice filing under Section 6(g) of the Exchange Act. There are 5 such registered exchanges. There are two exchanges that the SEC has exempted from registration on the basis of limited volume transactions.

    Continued Uncertainty

    Although the SEC is certainly correct that an online trading platform that trades securities must be licensed by the SEC, that would not be the case if the asset being traded is not a security. In fact, if the asset is a currency (and not a security) or a “thing” such as loyalty points, no US federal agency would regulate its trading. The SEC only regulates the trading of securities and security-related products. The CFTC has regulatory oversight over futures, options, and derivatives contracts on virtual currencies and has oversight to pursue claims of fraud or manipulation involving a virtual currency traded in interstate commerce. Beyond instances of fraud or manipulation, the CFTC generally does not oversee “spot” or cash market exchanges and transactions involving virtual currencies that do not utilize margin, leverage or financing.  Rather, these “exchanges” are regulated as payment processors or money transmitters under state law.

    Likewise, no federal regulator has direct jurisdiction over “exchanges” that trade loyalty points such as converting airline points to use for hotels, cars, consumer goods and services, or cash.  Online platforms such as www.points.com and www.webflyer.com operate using contractual partnerships with entities that issue loyalty points. In fact, points.com is owned by Points International Ltd., which trades on the TSX and Nasdaq and refers to itself as “the global leader in loyalty currency management.” Certainly, today there is a vast difference in the trading of loyalty points versus those looking to make profits in cryptocurrency trading, but there are also analogies, especially with the “currency” side.  In a recent 6-K, Points has this to say about the loyalty industry:

    Year-over-year, loyalty programs continue to generate a significant source of ancillary revenue and cash flows for companies that have developed and maintain these loyalty programs. According to the Colloquy group, a leading consulting and research firm focused on the loyalty industry, the number of loyalty program memberships in the US increased from 3.3 billion in 2014 to 3.8 billion in 2016, representing an increase of 15% (source: 2017 Colloquy Loyalty Census Report, June 2017). As the number of loyalty memberships continues to increase, the level of diversification in the loyalty landscape is evolving. While the airline, hotel, specialty retail, and financial services industries continue to be dominant in loyalty programs in the US, smaller verticals, including the restaurant and drug store industries are beginning to see larger growth in their membership base. Further, newer loyalty concepts, such as large e-commerce programs, daily deals, and online travel agencies, are becoming more prevalent. As a result of this changing landscape, loyalty programs must continue to provide innovative value propositions in order to drive activity in their programs.

    Companies that believe that their crypto is truly a utility with currency value may feel they have more in common with a loyalty point than a security, and regulators have yet to be able to give any level of firm ground on which to stand.

    In a hearing before the House Financial Services Committee on May 16, 2018, Stephanie Avakian, co-director of the SEC Division of Enforcement, told lawmakers that the SEC will continue to look at each case involving a cryptocurrency on a facts-and-circumstances basis. Ms. Avakian and co-director Steven Peiken both gave testimony and sat in the hot seat. The Financial Services Committee members were pushing for more definitive input on how ICOs should be defined and regulated, without result. The hearing became contentious, with Committee members becoming frustrated with the lack of direction and lack of certainty from the SEC as to how they define and view cryptocurrencies, other than “on a case-by-case basis” and using the same federal securities principles that already exist – a mantra that has been repeated.

    However, the SEC enforcement division could rightfully feel they are being put in an unfair position with this line of questioning.  Commissioner Hester M. Peirce warned against rulemaking by enforcement in a recent speech. Ms. Peirce has strong opinions on the subject.  She states, “[D]ue process starts with telling individuals in advance what actions constitute violations of the law.” She continues with “[A] related issue to which I am paying attention is the degree to which our enforcement process is being used to push the bounds of our authority. Congress sets the parameters within which we may operate, and we ought not to stray outside those boundaries through, for example, overly broad interpretations of  ‘security’ or extraterritorial impositions of the law. Our canons of ethics specifically caution us against exceeding ‘the proper limits of the law’ and argue for us remaining ‘consistent with the statutory purposes expressed by the Congress.’”

    In fairness, Ms. Peirce was talking in the context of enforcement as a whole. Not once did she mention cryptocurrencies, ICOs or blockchain in that speech.  However, in light of the prevalence of the topic and many industry leaders, politicians and market participants looking to the SEC for guidance on the question of “what is a cryptocurrency” and “how should it be regulated,” I can’t help but think the SEC is looking back at Congress with the same question.

    Further Reading on DLT/Blockchain and ICOs

    For a review of the 2014 case against BTC Trading Corp. for acting as an unlicensed broker-dealer for operating a bitcoin trading platform, see HERE.

    For an introduction on distributed ledger technology, including a summary of FINRA’s Report on Distributed Ledger Technology and Implication of Blockchain for the Securities Industry, see HERE.

    For a discussion on the Section 21(a) Report on the DAO investigation, statements by the Divisions of Corporation Finance and Enforcement related to the investigative report and the SEC’s Investor Bulletin on ICOs, see HERE.

    For a summary of SEC Chief Accountant Wesley R. Bricker’s statements on ICOs and accounting implications, see HERE.

    For an update on state-distributed ledger technology and blockchain regulations, see HERE.

    For a summary of the SEC and NASAA statements on ICOs and updates on enforcement proceedings as of January 2018, see HERE.

    For a summary of the SEC and CFTC joint statements on cryptocurrencies, including The Wall Street Journal op-ed article and information on the International Organization of Securities Commissions statement and warning on ICOs, see HERE.

    For a review of the CFTC role and position on cryptocurrencies, see HERE.

    For a summary of the SEC and CFTC testimony to the United States Senate Committee on Banking Housing and Urban Affairs hearing on “Virtual Currencies: The Oversight Role of the U.S. Securities and Exchange Commission and the U.S. Commodity Futures Trading Commission,” see HERE.

    To learn about SAFTs and the issues with the SAFT investment structure, see HERE.

    To learn about the SEC’s position and concerns with crypto-related funds and ETFs, see HERE.

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    Multiple Classes of Stock and the Public Company

    Tuesday, June 5, 2018, 7:54 AM [General]
    0 (0 Ratings)

    In March 2017, Snap Inc. completed its IPO, selling only non-voting Class A common shares to the investing public and beginning an ongoing discussion of the viability and morality of multiple classes of stock in the public company setting. No other company has gone public with non-voting stock on a U.S. exchange.  Although Facebook and Alphabet have dual-class stock structures, shareholders still have voting rights, even though insiders hold substantial control with super-voting preferred stock.

    Snap’s stock price was $10.79 on May 7, 2018, well below is IPO opening price of $17.00. Certainly the decline has a lot to do with the company’s floundering app, Snapchat, which famously lost $1.3 billion in value when reality star Kylie Jenner tweeted that she no longer used the app, but the negativity associated with the share structure has made it difficult to attract institutional investors, especially those with a history of activism. Although there was a net increase of $8.8 million in institutional ownership in the company for the quarter ending March 2018, the approximate 20% total institutional ownership is below average for the Internet software/services industry and the increase in the quarter resulted from purchases by 2 institutions where 8 others decreased their holdings.

    Moreover, many institutions, including pension funds, have holdings in Snap because they buy index funds, including ETFs, and Snap is in the S&P 500. The Council of Institutional Investors has even sent Snap a letter urging it to reconsider its share structure.

    The discussion has gained regulatory attention as well. On February 15, 2018, SEC Commissioner Robert J. Jackson Jr. gave a speech entitled “Perpetual Dual-Class Stock: The Case Against Corporate Royalty” in which he talked about the detriments of closely held perpetual control stock in a public company.

    Days prior to Commissioner Jackson’s speech, Commissioner Kara Stein gave a speech at Stanford University about the role of corporate shareholders.  Commissioner Stein posits that the relationship between a company and its shareholders should be mutual, including in areas involving cyber threats, board composition, shareholder activism and dual-class capital structures. Stein sees dual-class structures as purposefully disenfranchising shareholders and being inherently undemocratic.

    Perhaps feeling the pressure, on May 2, 2018, Zynga founder Mark Pincus announced he will convert his super-voting preferred stock into common stock, eliminating the company’s dual-class structure.  As a result of the conversion, Pincus’ voting power was reduced from 70% to 10%. His prior 10% economic stake remains unchanged.

    SEC Commissioner Robert J. Jackson Jr.’s Speech: Perpetual Dual-Class Stock: The Case Against Corporate Royalty

    On February 15, 2018, SEC Commissioner Robert J. Jackson Jr., gave a speech entitled “Perpetual Dual-Class Stock: The Case Against Corporate Royalty” at the University of California, Berkley campus.  Commissioner Jackson began the substantive portion of his speech with a summary background of a dual-class stock structure.  I’ve supplemented his explanation with additional information.

    Dual-class voting typically involves two more or more classes of stock, with one class having significantly more voting power than the others. The higher voting shares are often called “super-voting.” Typically, in a dual-class structure, the equity issued to the public is common equity with one vote per share and equity issued to insiders would be super-voting preferred stock. A company may also have other classes of preferred stock with various rights issued to different investors.  Snap’s issuance of non-voting common stock to the public takes this structure one step further.

    Historically, the NYSE did not allow companies to go public with dual-class voting structures. However, the takeover battles in the 1980s resulted in a change in the rules to allow for insider and management anti-takeover voting protection. Today, it is common for companies to go public with dual classes of voting stock.  Public companies using dual-class are today worth more than $5 trillion, and more than 14% of the 133 companies that listed on U.S. exchanges in 2015 have dual-class voting. That compares with 12% of firms that listed on U.S. exchanges in 2014, and just 1% in 2005. Nearly half of the companies with dual-class shares give corporate insiders super-voting rights in perpetuity.

    Commissioner Jackson acknowledges the reasons for a dual-class structure, and the desire by entrepreneurs and founders to go public while retaining control; however, he also quickly asserts that such a structure undermines accountability. Prior to accessing public markets, management control is beneficial in that it allows visionaries and entrepreneurs to innovate and disrupt industries without the short-term pressure of a loss of control over their efforts. However, perpetual outsized voting rights not only provide ultimate control to founders and entrepreneurs, but to their heirs as well, who may or may not be strong managers, entrepreneurs and visionaries.

    Although many market players are recently strongly advocating for a change in rules to prohibit companies from going public with a dual-class structure, Commissioner Jackson advocates a change such that a dual-class structure has a time limit or expiration date. There may be benefits to management control for a period of time, but that benefit ultimately runs out after a company is public and certainly once the founding management retires, leaves, passes away or otherwise ceases their entrepreneurial run. He suggests that the exchanges propose amended rules in this regard.

    Commissioner Jackson waxes philosophical pointing out the foundation of the United States origins, the Constitution and government structure, all of which are designed to allow for a change in regime and a vote by the masses. Even in public markets, power is not meant to continue in perpetuity, which is one of the reasons that the U.S. requires public companies to report and provide disclosure to investors and shareholders. Jackson likens perpetual super-voting stock as creating corporate royalty.

    However, for the sake of the debate, I note that in the free market system, it is likely that if management that holds super-voting shares does not perform, the underlying business will lose value, consumers will stop buying the product, and institutions will stop owning the stock and investing. The corporate royalty would then be under self-preserving pressure to be acquired by a stronger competitor with a better management team.

    In fact, Jackson continues his speech with analytics indicating that companies with super-voting insider control, do not perform as well as their counterparts. A recent study by Martijn Cremers, Beni Lauterbach, and Anete Pajuste entitled The Life-Cycle of Dual-Class Firms (Jan. 1, 2018) shows that the costs and benefits of dual-class structures change over time, with such companies trading at a premium shortly after the IPO, but decreasing over time.

    Jackson’s staff studied 157 dual-class IPOs that occurred within the past 15 years.  Of the 157 companies, 71 had sunset provisions or provisions that terminated the dual-class structure over time, and 86 gave insiders control forever. Whereas the companies traded relatively equally for the first few years, after seven years, those with a perpetual dual-class structure traded at a substantial discount to the others. Furthermore, when a company with a perpetual dual-class structure voluntarily eliminated the second control class, there was a significant increase in valuation.

    As mentioned, institutional investors and market participants have vocally opposed dual-class structures for public companies. In December 2017, the Investor as Owner Subcommittee of the SEC’s Investor Advisory Committee published a report entitled Discussion Draft: Dual Class and Other Entrenching Governance Structures in Public Companies strongly opposing the structure. In addition to its letter to Snap, the Council of Institutional Investors has published a page on its website discussing and advocating for one-share equal voting rights for public companies.

    Furthermore, the FTSE Russell index will now exclude all companies whose float is less than 5% of total voting power, the S&P Dow will now exclude all dual-class companies and the MSCI will reduce dual-class companies from its indexes. Commissioner Jackson is concerned that excluding dual-class stock companies from indexes does more harm than good. Many Main Street investors own public equities through funds or ETFs that in turn either own or mirror indexes. By removing dual-class companies from index funds, Main Street investors lose the opportunity to invest in these companies, some of which are the most innovative in the country today.

    Commissioner Jackson’s suggestion of finding a middle ground whereby a company could complete an IPO with a dual-class structure and allow its visionaries to build without short-term shareholder pressure, but then limiting that sole control to a defined period, was met with praise and approval. Several market participants, including the SEC’s Investor Advisory Committee and the Council of Institutional Investors, made comments supporting the suggestion.

    More on Preferred Equity

    Although the topic of super-voting features in dual-class stock structures has been hotly debated recently, it is not the only feature that may be in preferred stock.  Preferred stock is the most commonly used investment instrument due to its flexibility. Preferred stock can be structured to offer all the characteristics of equity as well as of debt, both in financial and non-financial terms. It can be structured in any way that suits a particular deal. The following is an outline of some of the many features that can be included in a preferred stock designation:

    1. Dividends a dividend is a fixed amount agreed to be paid per share based on either the face value of the preferred stock or the price paid for the preferred stock (which is often the same); a dividend can be in the form of a return on investment (such as 8% per annum), the return of investment (25% of all net profits until the principal investment is repaid) or a combination of both. Although a dividend can be structured substantially similar to a debt instrument, there can be legal impediments to a dividend payment and a creditor generally takes priority over an equity holder. The ability of an issuer to pay a dividend is based on state corporate law, the majority of which require that the issuer be solvent (have the ability to pay creditors when due) prior to paying a dividend. Accordingly, even though the issuer may have the contractual obligation to pay a dividend, it might not have the ability (either legally or monetarily) to make such payments;

    – As a dividend may or may not be paid when promised, a dividend either accrues and cumulates (each missed dividend is owed to the preferred shareholder) or not (we didn’t get the dividend this quarter, but hopefully next);

    – Although a dividend payment can be structured to be paid at any interval, payments are commonly structured to be paid no more frequently than quarterly, and often annually;

    – Dividends on preferred stock are generally preferential, meaning that any accrued dividends on preferred stock must be fully paid before any dividends can be paid on common stock or other junior securities;

    1. Voting Rights as discussed, preferred stock can be set up to establish any level of voting rights from no voting rights at all, voting rights on certain matters (sole vote on at least one board seat; voting rights as to the disposition of a certain asset but otherwise none), or super-voting rights (such as 10,000 to 1 or 51% of all votes);
    2. Liquidation Preferences a liquidation preference is a right to receive a distribution of funds or assets in the event of a liquidation or sale of the company issuer.  Generally creditors take precedence over equity holders; however, preferred stock can be set up substantially similar to a debt instrument whereby a liquidation preference is secured by certain assets, giving the preferred stockholder priority over general unsecured creditors vis-à-vis that asset.  In addition, a liquidation preference gives the preferred stockholder a priority over common stockholders and holders of other junior equities. The liquidation preference is usually set as an amount per share and is tied into the investment amount plus accrued and unpaid dividends;

    – In addition to a liquidation preference, preferred stockholders can partake in liquidation profits (for example, preferred stockholder gets entire investment back plus all accrued and unpaid dividends, plus 30% of all profits from the sale of the company issuer; or preferred stockholder gets entire investment back plus all accrued and unpaid dividends and then participates pro rata with common stockholders on any remaining proceeds (known as a participating liquidation preference);

    1. Conversion or exchange rights a conversion or exchange right is the right to convert or exchange into a different security, usually common stock;

    – Conversion rights include a conversion price which can be set as any mathematical formula, such as a discount to market (75% of the average 7-day trading price immediately prior to conversion); a set price per share (preferred stock with a face value of $5.00 converts into 5 shares of common stock thus $1.00 per share of common stock); or a valuation (converts at a company valuation of $30,000,000);

    – Conversion rights are generally at the option of the stockholder, but the issuer can have such rights as well, generally based on the happening of an event such as a firm commitment underwriting (the issuer has the right to convert all preferred stock at a conversion price of $10.00 per share upon receipt of a firm commitment for the underwriting of a $50,000,000 IPO);

    – The timing of conversion rights must be established (at any time after issuance; only between months 12 and 24; within 90 days of receipt of a firm commitment for a financing in excess of $10,000,000);

    – conversion rights usually specify whether they are in whole or in part and, for public companies, limits are often set (conversion limited such that cannot own more than 4.99% of outstanding common stock at time of conversion);

    1. Redemption/put rights a redemption right in the form of a put right is the right of the holder to require the issuer to redeem the preferred stock investment (to “put” the preferred stock back to the issuer); the redemption price is generally the face value of the preferred stock or investment plus any accrued and unpaid dividends; redemption rights generally kick in after a certain period of time (5 years) and provide an exit strategy for a preferred stock investor;
    2. Redemption/call rights a redemption right in favor of the issuer is a call option (the issuer can “call” back the preferred stock); generally when the redemption right is in the form of a call a premium is placed on the redemption price (for example, 125% of face value plus any accrued and unpaid dividends or a pro rata share of 2.5 times EBITDA);
    3. Anti-dilution protection anti-dilution protection protects the investor from a decline in the value of their investment as a result of future issuances at a lower valuation.  Generally the issuer agrees to issue additional securities to the holder, without additional consideration, in the event that a future issuance is made at a lower valuation such as to maintain the investors overall value of investment; an anti-dilution provision can also be as to a specific percent ownership (the holder will never own below 10% of the total issued capital of the issuer);
    4. Registration rights registration rights refer to SEC registration rights and can include demand registration rights (the holder can demand that the issuer register their equity securities) or piggyback registration rights (if the issuer is registering other securities, it will include the holder’s securities as well);
    5. Transfer restrictions preferred stock can be subject to transfer restrictions, either in the preferred stock instrument itself or separately in a shareholder’s or other contractual agreement; transfer restrictions usually take the form of a right of first refusal in favor of either the issuer or other security holders, or both;
    6. Co-sale or tag along rights co-sale or tag-along rights are rights of holders to participate in certain sales of stock by management or other key stockholders;
    7. Drag-along rights drag-along rights are the rights of the holder to require certain management or other key stockholders to participate in a sale of stock by the holder;
    8. Other non-financial covenantspreferred stock, either through the instrument itself or a separate shareholder or other contractual agreement, can contain a myriad of non-financial covenants, the most common being the right to appoint one or more persons to the board of directors and to otherwise assert control over management and operations; other such rights include prohibitions against related party transactions; information delivery requirements; non-compete agreements; confidentiality agreements; limitations on management compensation; limitations on future capital transactions such as reverse or forward splits; prohibitions against the sale of certain key assets or intellectual property rights; in essence non-financial covenants can be any rights that the preferred stockholder investor negotiates for.

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    SEC Continues to Review, And Delay, Crypto Funds

    Tuesday, May 22, 2018, 8:22 AM [General]
    0 (0 Ratings)

    On January 18, 2018, the SEC issued a letter to the Investment Company Institute and the Securities Industry and Financial Markets Association (SIFMA) explaining why the SEC could not approve a cryptocurrency-related exchange traded fund (ETF) or mutual fund. The letter, authored by SEC Division of Investment Management director Dalia Blass, explains the SEC’s reservations and concerns about approving a crypto-related mutual fund or ETF. The letter advised against seeking registration of funds that invest heavily in cryptocurrency-related products until the raised questions and concerns can be properly addressed.

    The SEC letter comes a year after the SEC rejected a proposal by Cameron and Tyler Winklevoss, famously linked to the founding of Facebook, to create a bitcoin-tracking ETF. Since that time the SEC has privately rejected several similar requests. Many in the industry appreciate the SEC letter as it offers specific guidance and concrete issues to be addressed as the march towards the eventual approval of a crypto-related fund continues.

    Since the January 18 letter, the SEC has been reviewing and conducting proceedings on a New York Stock Exchange (NYSE) proposal to list and trade five bitcoin-related ETFs. The proceedings are expected to go on for a few months. This blog will begin with an explanation of what exactly is an ETF and then address the SEC’s concerns related to the clearance of crypto-related ETFs.

    What is an ETF?

    Exchange traded funds or ETFs are funds that track indexes. Historically, exchange traded funds have tracked big-board indexes such as the Nasdaq 100, S&P 500 or Dow Jones; however, as ETFs have risen in popularity, there are now funds that track lesser-known indexes or specially created indexes to feed the ETF market. There are indexes based on market sectors, such as tech, healthcare, financial; foreign markets; market cap (micro-, small-, mid-, large-, and mega-cap); asset type (small-growth, large-growth, etc.); and commodities. The primary difference between an ETF and other index funds is that an ETF does not try to outperform the corresponding index, but rather tries to track and replicate the performance.

    An ETF allows an investor the advantage of copying an index with a single stock trade, without the risk associated with a fund manager trying to outperform the market.  Since the fund manager is simply copying and mirroring the particular index, the management style is referred to as “passive management.”

    Passive management reduces the administrative costs from an actively managed portfolio, and that savings can be passed down to the investors. A typical private hedge fund charges 2% per annum for administrative fees. That fee is reduced to 1% for mutual or registered funds. The typical fee for an ETF is less than .20% per year. Moreover, since an ETF does not trade as actively as typical funds, it has fewer capital gain events and therefore lower taxes.

    An ETF trades just like a stock, with continuous trading throughout a day. ETFs are generally margin-eligible and accordingly can be sold short. Conversely, mutual funds are generally only priced once a day after market closings and are not margin-eligible.

    ETFs have become increasingly popular over the years, especially with investors that are interested in market sectors, regions or asset types. It is not surprising that investors are interested in crypto-related ETFs and that fund creators are likewise trying to meet this investor demand.

    SEC Position on Crypto-related Mutual Funds and ETFs

    As mentioned, On January 18, 2018, the SEC Division of Investment Management issued a letter to the Investment Company Institute and the Securities Industry and Financial Markets Association (SIFMA) explaining why the SEC could not approve a cryptocurrency-related exchange traded fund (ETF) or similar investment product such as a mutual fund.

    The SEC begins with its commitment to fostering innovation and the development of new types of investment products, ETFs being a primary example, but quickly continues with the assertion that multiple investor protection issues need to be resolved before a crypto-related fund could be offered.  The primary issues are valuation, liquidity, custody, arbitrage, potential manipulation and other risks.

    The concerns and questions raised by the SEC will also impact future changes to exchange listing standards by the Division of Corporation Finance, the Division of Trading and Markets and the Office of the Chief Accountant. The SEC foresees needed changes to accounting, auditing and reporting requirements for crypto-related funds and ETFs.

    Valuation

    Mutual funds and ETFs must value their assets on each business day in order to reach a net asset value (“NAV”). NAV is used to determine fund performance, what investors pay for mutual funds and what authorized participants pay for ETFs as well as what they receive when they redeem or sell. The SEC is concerned that a fund or ETF would not have the necessary information to value a cryptocurrency as a result of their volatility, fragmentation, lack of regulation, nascent state and current trading volume (or lack thereof) in the cryptocurrency futures markets.

    The SEC has requested that the industry evaluate and provide information as to how valuations would be conducted. Furthermore, the SEC has asked how funds would develop and implement policies and procedures related to crypto-related valuations to ensure that the requirements as to fair value are met. Likewise, the SEC would need satisfaction that a fund or ETF could adequately address the accounting and valuation impacts of “forks” such as when a cryptocurrency diverges into two separate currencies with different prices.

    The SEC questions the policies a fund would implement to identify and determine eligibility and acceptability for newly created cryptocurrencies. The SEC has concern as to how a fund would consider the impact of market information and manipulation in the underlying cryptocurrency markets as related to the determination of the settlement price of cryptocurrency futures.

    Liquidity

    Investments in open-ended funds such as mutual funds and ETFs are redeemable on a daily basis and as such, the funds must maintain sufficient liquid assets to satisfy redemptions.  Rule 22e-4 promulgated under the Investment Company Act of 1940 (the “1940 Act”) requires funds to implement liquidity risk management programs. Under the rule, funds must classify their investments into one of four liquidity categories and limit their investments in illiquid securities to 15% of the fund’s assets.

    The SEC is concerned with the steps a fund or ETF that invests in cryptocurrencies or crypto-related products would take to ensure that it would have sufficient liquidity to meet daily redemptions. Moreover, the SEC raises questions as to how such funds would satisfy Rule 22e-4 and in particular, how could any crypto-related investment be classified as anything other than illiquid under the rule.

    The SEC specifically asks how such funds would take into account the trading history, price volatility and trading volume of cryptocurrency futures contracts, and would funds be able to conduct a meaningful market-depth analysis in light of these factors.  Similarly, given the fragmentation and volatility in the cryptocurrency markets, would these funds need to assume an unusually sizable potential daily redemption amount in light of the potential for steep market declines in the value of underlying assets.

    Custody

    The 1940 Act provides for certain requirements related to the custody of securities held by funds, including who may act as a custodian and when funds must verify holdings. The SEC questions how a fund or ETF could satisfy the custody requirements for cryptocurrency-related products. The SEC notes that there are currently no custodians providing fund custodial services for cryptocurrencies. Likewise, although currently all bitcoin future contracts are cash-settled, if physical settlement contracts develop, the SEC questions how a fund will custody the bitcoin to make delivery.

    The SEC further questions how a fund will validate existence, exclusive ownership and software functionality of private cryptocurrency keys and other ownership records.  Another issue for cryptocurrencies is cybersecurity and the threat of hacking.  The SEC has concerns about how custodians can satisfy their requirements for the safekeeping of crypto assets.

    Arbitrage for ETFs

    ETFs obtain SEC orders that enable them to operate in a specialized structure that provides for both exchange trading of their shares throughout the day at market-based prices, and “creation unit” purchases and redemptions transacted at NAV by authorized participants. In order to promote fair treatment of investors, an ETF is required to have a market price that would not deviate materially from the ETF’s NAV. The SEC questions how an ETF could comply with the terms of an order considering the fragmentation, volatility and trading volume in the cryptocurrency marketplace.

    The SEC would like funds to engage with market makers and authorized participants to understand the feasibility of the arbitrage for ETFs investing substantially in cryptocurrency and cryptocurrency-related products. The SEC also questions how trading halts or the shutdown of a cryptocurrency exchange would affect the market price or arbitrage.

    Potential Manipulation and Other Risks

    The SEC believes that the current cryptocurrency markets have substantially fewer investor protections than traditional securities markets. Moreover, the SEC, other federal regulators, and state regulators have found considerable fraud in the cryptocurrency marketplace. The SEC is concerned about how a fund would address fraud concerns in the underlying markets when offering investments in the fund to retail investors. Similarly, the SEC is concerned about the disclosure of, and ability for a retail investor to understand, the risks of an investment in a crypto-related fund.

    Likewise, the SEC would like funds to engage in discussions with broker-dealers who may distribute the funds, as to how the broker-dealer will satisfy their suitability requirements. The SEC is also concerned with how an investment advisor will satisfy their fiduciary obligations when recommending a crypto-related fund.

    Further Reading on DLT/Blockchain and ICOs

    For an introduction on distributed ledger technology, including a summary of FINRA’s Report on Distributed Ledger Technology and Implication of Blockchain for the Securities Industry, see HERE.

    For a discussion on the Section 21(a) Report on the DAO investigation, statements by the Divisions of Corporation Finance and Enforcement related to the investigative report and the SEC’s Investor Bulletin on ICOs, see HERE.

    For a summary of SEC Chief Accountant Wesley R. Bricker’s statements on ICOs and accounting implications, see HERE.

    For an update on state-distributed ledger technology and blockchain regulations, see HERE.

    For a summary of the SEC and NASAA statements on ICOs and updates on enforcement proceedings as of January 2018, see HERE.

    For a summary of the SEC and CFTC joint statements on cryptocurrencies, including The Wall Street Journal op-ed article and information on the International Organization of Securities Commissions statement and warning on ICOs, see HERE.

    For a review of the CFTC role and position on cryptocurrencies, see HERE.

    For a summary of the SEC and CFTC testimony to the United States Senate Committee on Banking Housing and Urban Affairs hearing on “Virtual Currencies: The Oversight Role of the U.S. Securities and Exchange Commission and the U.S. Commodity Futures Trading Commission,” see HERE.

    To learn about SAFTs and the issues with the SAFT investment structure, see HERE.

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