The CFTC takes the position that Bitcoin and other blockchain-based virtual currencies are “commodities” under Section 1a(9) of the CEA, and thus subject to regulation by the CFTC:
“Section 1a(9) of the [CEA] defines ‘commodity’ to include, among other things, ‘all services, rights, and interests in which contracts for future delivery are presently or in the future dealt in.’ 7 U.S.C. § 1a(9). The definition of a ‘commodity’ is broad. See, e.g., Board of Trade of City of Chicago v. SEC, 677 F. 2d 1137, 1142 (7th Cir. 1982). Bitcoin and other virtual currencies are encompassed in the definition and properly defined as commodities.” [In Re-Coinflip, Inc., d/b/a Derivabit, and Francisco Riordan.]”
The Coinflip case involved a website that allowed the trading of off-exchange options and futures contracts on cryptocurrencies. The CFTC took the position that the underlying cryptocurrencies were commodities, and therefore options and futures contracts on cryptocurrencies are subject to CFTC regulation. The case was settled by the defendants, and to date, no Federal court has ruled on the issue.
In contrast, in its October 2017 Primer on Virtual Currencies, the CFTC staff stated: “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.” So, it appears that the CFTC believes that a private fund that invests directly in cryptocurrencies without leverage would not be deemed a commodity pool and the fund manager would not need to register as a CPO.
The result is that managers of cryptocurrency funds that invest in cryptocurrency futures contracts or margined or leveraged cryptocurrency investments, as opposed to straight cryptocurrencies, probably do need to register as CPOs with the CFTC, unless they can satisfy an exclusion from the definition of a CPO or exemption from the registration requirements. There most common exemption for private commodity pools is under CFTC Regulation 4.7, which provides a partial exemption for registered CPOs operating commodity pools whose participants are limited to “qualified eligible persons” and with respect to CTAs who advise “qualified eligible persons,” as defined in the regulation. Briefly stated, qualified eligible persons include such persons as certain investment professionals, knowledgeable employees, qualified purchasers, non-United States persons, and accredited investors who meet a portfolio requirement. In most cases, this requires investors in the pool to have at least $2 million in liquid investments. In order to qualify for this exemption, the CTO needs to make an abbreviated filing with the CFTC.
Regulation of Cryptocurrency Funds and their Managers under the U.S. Investment Advisers Act
Investment advisors, including managers and general partners of hedge funds, venture capital funds and other private investment funds that invest in securities, must register as registered investment advisors (RIAs) with the SEC or the securities regulators of the states in which they operate, unless they can qualify for an exemption from registration. The governing statute at the Federal level is the Investment Advisers Act of 1940 (the Advisers Act).
For funds investing in cryptocurrencies and tokens without using leverage or derivatives, the fund manager would not need to register as an RIA if the cryptocurrencies and tokens are not securities. Unfortunately, as discussed below and on our ICO page, the law is unclear as to whether and under what conditions a token will be considered to be a security. For this reason, many lawyers are advising their fund clients to assume that the underlying token investments will be deemed to be securities, and to register as RIA’s if a suitable exemption is not available.
Regulation of the Offering of Fund Units under the Securities Act of 1933
Most funds will be structured as limited partnerships or, less common, as limited liability companies. The limited partnership or LLC investment units in the fund that are sold to investors are securities, and their offering must be in accordance with an exemption from registration under the Securities Act of 1933 (the Securities Act). This will typically be either Regulation D, Rule 506, for private placements of fund units to accredited investors, or Regulation S for offerings solely to non-U.S. persons. Accredited investors include individuals with net worth, exclusive of their primary residence, of at least $1 million, or annual net income in the past two years of $200,000 (or $300,000 joint income with their spouse).
When are Tokens Securities?
As we have seen, the question whether a particular token is a security is crucial for determining whether a private fund manager needs to register as an RIA under the Advisers Act and state investment advisor laws. In addition, private investment funds that invest in securities must be structured to avoid the registration requirements of the Investment Company Act of 1940 (the Investment Company Act), discussed below, which governs mutual funds, unit investment trusts, exchange traded funds (ETFs) and other vehicles that invest in portfolios of securities.
The issue also comes up for portfolio companies when they make an ICO or other offering of tokens. If the tokens are securities, then they must be registered with the SEC under the Securities Act, unless an exemption from registration is available. This is discussed further on our ICO page.
Exemptions under the Advisors Act for Private Fund Managers
An investment advisor that manages at least $100 million in assets must register with the SEC unless an exemption is available. For startup fund managers with less than $100 million in assets under management, investment advisors must register with the state regulators in which the investment advisor is located; they may also register with the SEC if their assets under management are at least $25 million.
There are several exemptions from registration that may be available to managers of cryptocurrency and token funds:
Private Fund Advisors. This exemption is available to advisors solely to “private funds” that have less than $150 million in assets under management in the United States.
There are two types of private funds. The first is a fund that no more than 100 investors and that does not publicly offer its securities. There are also complicated “look-through” provisions that disregard groups of investors who form an LLC or other entity to invest; in this case the fund has to count the number of LLC owners towards the 100-investor cap unless no more than 40% of the LLC’s assets can be invested in the Fund. It should be noted that an advisor to this type of fund may not charge a performance fee (including a carried interest in favor of the manager) to any investor who is not a “qualified client.” Qualified clients include those with at least $1 million under management with the advisor, those with a net worth of at least $2.1 million, and “qualified purchasers” (defined below).
The second type of private fund is a fund that does not publicly offer its securities and limits its owners to “qualified purchasers,” which generally include natural persons who own at least $5 million in investments. In this case, there is no limitation on the ability to charge a carried interest or other performance fee.
Venture Capital Advisors. An adviser that solely advises one or more “venture capital funds” is exempt from registration under the Advisors Act. In certain circumstances, a fund that invests primarily in ICOs may qualify as a venture capital fund.
To qualify as a venture capital fund, the fund may invest only in “qualifying investments” and short-term investments, subject to a basket for non-qualifying investments of 20% of the fund’s capital commitments. “Qualifying investments” are generally equity securities of a “qualifying portfolio company” that are acquired by the fund directly from the qualifying portfolio company or in limited circumstances in exchange for such directly acquired qualifying securities. (I.e., no purchases for existing shareholders and no non-equity securities.) A “qualifying portfolio company” is a company that: (1) is not a reporting or foreign traded company at the time of investment; (2) does not incur leverage in connection with the fund’s investment and distribute to the fund the proceeds of the leverage in exchange for the investment (i.e., no LBO’s); and (3) is not a fund or commodity pool (i.e., no fund of funds transactions.) . Note that the investments must be equity securities, which mean that the token must not only be a security but must represent equity in the issuer (e.g., entitled to a share of profits, possibly with voting rights).
The fund must: (1) be a private fund (i.e., less than 100 investors or qualified purchasers only) that does not borrow or otherwise incur leverage, except for certain short-term borrowing not in excess of 15% of the fund’s aggregate capital contributions and uncalled capital commitments; (2) represent to investors and potential investors that it peruses a venture capital strategy; (3) not permit its investors to redeem their interests except under extraordinary circumstances; and (4) not be registered under the Investment Company Act and not have elected to be treated as a business development company under the Investment Company Act.
Certain Commodity Trading Advisors. Under limited circumstances, a registered CTA that only advises private pools does not need to register as an RIA. The main limitation is that if and when the fund manager’s business becomes predominantly the provision of securities-related advice, it must then register as an RIA. While this exemption might be available for the manager of an ICO fund where the cryptocurrencies are commodities but not securities, it would not be available for a fund that invests in securities tokens.
Cryptocurrency Funds and the Investment Company Act
The Investment Company Act requires investment companies to register with the SEC unless they qualify for an exemption. “Investment companies” include mutual funds and other entitles that are engaged primarily in the business of investing, reinvesting, or trading in securities. Registration under the Investment Company Act is an expensive and time-consuming process, similar to an IPO under the Securities Act, and investment companies are subject to extensive ongoing regulation.
ICO funds can be structured under one of two exemptions from registration under the Investment Company Act.
Section 3(c)(1) of the Investment Company Act provides an exemption for a fund with no more than 100 beneficial owners that has not and does not intend to make a public offering of its securities.
Section 3(c)(7) exempts funds with an unlimited number of investors, but requires a each investor to have a significantly higher net worth suitability requirement as a “qualified purchaser” (net worth of roughly $5 million for individuals, $25 million for entities). As a general rule, many startup funds are structured as 3(c)(1) funds because of the lower investor suitability requirements.
Until the SEC and the courts provide better guidance on the conditions under which tokens will be treated as securities, fund managers who do not comply with one of these Investment Company Act exemptions risk violating the Act. The likelihood of tokens being deemed securities is great enough that startup token funds should assume that they are and thus comply with the Investment Company Act. For most startup funds, this would mean limiting investors within a given fund to less than 100 beneficial owners.
Our ICO Fund Practice
We provide a full range of services to clients wishing to set up private funds, including advice on the optimal structure given the client’s business objectives and regulatory licenses. We can also assist in registration under the CEA or Advisers Act for those clients whose activities will require those licenses.