In today’s article, we will explore whether a Bitcoin hedge fund requires Securities and Exchange Commission (SEC) or Commodities and Futures Trading Commission (CFTC) registration.
What is a Bitcoin Hedge Fund?
A Hedge Fund (or Private Fund) is when you put two LLCs together, and allow the hedge fund owners/managers to be managing members of LLC #1, and then LLC #1 plus investors join LLC #2. Investors put their money (or Bitcoin) into the LLC #2 and the Hedge Fund manager invests it.
This structure avoids the need for the fund manager to register as a broker-dealer under the Exchange Act because they don’t effect transactions for the accounts of others — rather; they are trading on their own account. The Manager is still responsible to comply with the far-reaching antifraud provision of the Advisers Act.
The Manager can use any number of investment strategies, but depending on the strategy, it may implicate some cumbersome regulatory oversight. For example, having Bitcoin only hedge fund, and actively trading it likely does not implicate: (1) the SEC because Bitcoin is not a Security, it’s a commodity, and (2) the CFTC because the fund is not using leverage, margin, futures, swaps, or options on top of the commodity.
SEC Hedge Fund Jurisdictional Issues:
If the Hedge Fund invested in anything the SEC considers a Security; it would be required to register, or use an exemption from registration.
Investment Companies Act:
If the Hedge Fund was selling securities (I.E. ICO Tokens, or allowing for options, swaps, futures on top of Bitcoin), the Investment Company Act would generally require registration with the SEC unless they meet certain exemptions: (1) The 3c1 exemption applies when there are less than 100 investors, all of whom are accredited; and (2) The 3c7 exemption applies when there are up to 2,000 investors so long as the individuals have $5 million net worth. As a general rule, most startup funds are structured as 3(c)(1) funds because of the lower investor suitability requirements.
SEC Enforcement Actions against Crypto Hedge Funds:
The SEC has engaged in one action to date against a crypto hedge fund called Crypto Asset Management, LP (“CAM”) finding they were an unregistered investment company who invested over 40% of the fund in what the SEC deemed “digital asset securities” (aka ICO-generated coins). CAM agreed to the SEC’s cease-and-desist order and censure without admitting or denying the findings against them, and agreed to pay a penalty of $200,000.
If the fund is selling Securities, and the fund chooses to follow the Regulation D exemption from SEC registration, Rule 506(b) allows for general solicitation or advertising, so long as the fund only accepts proven accredited investors.
Which coins are Securities?
The SEC has used the Howey Test to identify when an Investment Contract has been created. An Investment contract is an enumerated security — kind of a catch-all — from the 1933 Act. A four-prong framework was created in S.E.C. v. W.J. Howey Co., where the following factors were necessary for the SEC to attach jurisdiction: (1) an investment of money, (2) into a common enterprise, (3) with an expectation of profits, and (4) derived solely from someone else’s work.
After years of case law that have relied and expanded on the Howey test, the investment of money prong has matured to encompass much more than just fiat dollars. In fact, in the Tomahawk ICO case, even an investment of time was considered sufficient. The common enterprise is also rather broad; it is anything where the fortunes of the investors are linked to the efforts of the promoter. The 11th Circuit described it well in Eberhardt v. Waters, “the thrust of the common enterprise test is that the investors have no desire to perform the chores necessary for a return, and are attracted to the investment solely by the prospects of a return.”
This analysis needs to be performed by a securities lawyer on a case-by-case basis, but there seems to be somewhat of a general consensus among the attorneys (who I know), and hopefully the SEC agrees, that coins generated from proof of work mining, such as litecoin, monero, raven, and some others do not meet the definition of an investment contract. It has been settled that Bitcoin is not a security.
Likewise, coins or tokens that were airdropped likely don’t qualify as investment contracts — although this opinion is more controversial and little guidance has been provided. A great discussion took place on Laura Shin’s Unchained podcast Episode 93, at approximately 53 minutes in.
Ethereum has unofficially received the green light that it is not a security based on Mr. Hinman’s “When Howey met Gary (Plastics)” speech that said the project was sufficiently decentralized so the Howey factors would not apply.
In SEC Commissioner Hester Pierce’s recent speech, she said, “When the tokens are not being sold as investment contracts, they are not securities at all. Tokens sold for use in a functioning network, rather than as investment contracts, fall outside the definition of securities.
Surrounding hedge funds, the SEC remains cautious, they said, “Recently, the growth in cryptocurrencies and cryptocurrency-related products has attracted significant attention, and we have seen interest among sponsors in offering registered funds that would hold these new digital products. As we have in the past, the Division stands ready to engage in dialogue with sponsors regarding the potential development of these funds. We believe, however, that there are a number of significant investor protection issues that need to be examined before sponsors begin offering these funds to retail investors.”
CFTC Hedge Fund Jurisdictional Issues:
It is likely that trading in Bitcoin (or other commodity coins) alone does not implicate CFTC oversight, but trading in Bitcoin futures, swaps, and OTC Bitcoin forward contracts may require CFTC and National Futures Association (NFA) registration as a Commodity Trading Advisor (CTA) or a Commodities Pool Operator (CPO).The CPO Operator must pass the Series 3. The was Coinflip, Inc. case did a good explanation.
An exemption from CFTC registration is available when: (1) The fund trades less than 5% of its assets in a leveraged fashion, does not advertise, and limits access to only accredited investors; (2) The Manager has less than 15 clients in the previous 12 months, and does not advertise; or (3) The fund does “registration lite” and limits the clients to “QEP”s that have income of $200K and net worth of 2 million.
CFTC Enforcement Actions against Crypto Asset Managers:
In October, 2017, a New York federal court has ordered New York corporation Gelfman Blueprint, Inc. (GBI) and its Chief Executive Officer Nicholas Gelfman of Brooklyn, New York, to pay in total over $2.5 million in civil monetary penalties and restitution in what was the first anti-fraud enforcement action involving Bitcoin filed by CFTC.
On September 27, 2018, the CFTC filed a civil enforcement action against Defendants 1pool Ltd. and its chief executive officer and owner, Patrick Brunner of Austria. The CFTC’s Complaint charges the Defendants with engaging in unlawful retail commodity transactions, failing to register as a Futures Commission Merchant (FCM), and supervisory violations for failing to implement procedures to prevent money laundering.
In conclusion, a Crypto Hedge Fund is required to register with the SEC if it sells any securities, and register with the CFTC if it does any kind of fancy leverage/swaps/futures on top of the base commodity.