Part 1 – Introduction
On September 11, 2018, the Securities and Exchange Commission (SEC or the Commission) announced “public administrative and cease-and-desist proceedings” against Crypto Asset Management, LP (CAM) and Timothy Enneking (Enneking), the owner and manager of CAM. The ruling is notable as the Commission’s first order against a crypto-dominated investment fund, but also stands out because it provides further definition to this rapidly changing area of asset management law and investing. With the announcement of the proceedings against CAM and Enneking, the SEC firmly puts its stake in the ground that initial coin offerings (ICOs) are indeed securities offerings and require registration or appropriate exemptions under the applicable provisions of the securities laws. Further, the Commission signals that rules violations that had been overlooked or ignored in past years, while regulators took time to better understand the cryptocurrency/digital asset marketplace, will now be subject to penalties.
The facts in the case are relatively straightforward. CAM and Enneking managed Crypto Asset Fund, LLC (CAF), a pooled asset vehicle organized for the purpose of investing in digital assets. Through the work of Enneking and CAM, CAF gathered $3.6 million in investments from 44 investors (primarily from individuals with whom they had no prior contact) residing in at least 15 states between August 1, 2017 and December 1, 2017, claiming an exemption from Securities Act of 1933 (Securities Act) registration under Regulation D Rule 506(b). On December 31, 2017, CAF held $37 million of assets, which it invested in products including digital assets. CAM earned management fees and incentive fees from its management agreement with CAF. In its findings, the SEC stated that CAM and Enneking violated portions of the Securities Act, the Investment Company Act (ICA) and the Investment Advisers Act (IAA). Not only did they fail to appropriately register the offering under the Securities Act or the fund under the ICA, but they misrepresented to investors that they were registered and incorrectly advertised themselves as the “first regulated crypto asset fund in the United States.” After being contacted by the SEC and informed of probable violations, CAM and Enneking took remedial action, including correcting material misstatements and making an offer of rescission to investors, and undertook a new offering pursuant to a Regulation D Rule 506(c) exemption. In addition, CAM and Enneking were fined a combined $200,000.
Part II – Legal Analysis
Of the statutory violations the SEC found, those under the Securities Act break the least new ground. On June 5, 2017, CAF filed Form D with the SEC, announcing its intention to offer limited partnership interests (securities) to investors, without a registration statement, pursuant to the exemption in Rule 506(b). Crucially, securities issuers relying on Rule 506(b) may not “offer or sell the securities by any form of general solicitation or general advertising.” The SEC found, however, that CAF, CAM, and Enneking “did not have pre-existing relationships with [several of CAF’s] investors and engaged in a general solicitation of public interest in the offering through CAM’s website, social media accounts, and traditional media outlet interviews.” Therefore, the offering was not eligible for Rule 506(b) and should have been registered. Furthermore, the SEC deemed CAM’s description of CAF as the “first regulated crypto asset fund in the United States” to be misleading, contrary to the Security Act’s bar on raising money “by means of any untrue statement of material fact.”
By conducting the offering without filing a registration statement, CAM caused CAF to violate the Securities Act. In addition, by misleading investors as to the availability of other crypto asset funds, CAM violated the Security Act’s anti-fraud provision. While the SEC’s order did not specify what portion of the $200,000 fine resulted from these violations, it did order CAM to “cease and desist from committing or causing any violations” of the Securities Act. CAM has now revised its website and marketing materials to remove the misrepresentations highlighted by the SEC, and CAF has filed an amended Form D to conduct its offering under Rule 506(c), which does permit general solicitation.
More relevant to the ICO industry were the SEC’s holdings with regard to the IAA and ICA. The SEC found that CAM’s description of CAF violated the IAA’s anti-fraud provision and that CAF should have registered with the SEC as an investment company prior to engaging in the business of “investing, holding, and trading certain digital assets.” This is significant because the IAA’s anti-fraud provision applies only if CAF was trading securities, and investment company registration should have been required only if CAF held securities that had, in the aggregate, “a value exceeding 40% of the value of CAF’s total assets (exclusive of Government Securities and cash items).”
Much debate in the blockchain community has focused on whether ICO tokens should qualify as “securities.” Status as a security would implicate multiple statutory and regulatory provisions, requiring those who advise on the purchase and sale of such tokens to register as investment advisers, those who facilitate trading in the same to register as broker-dealers, and those who issue such tokens to file registration statements or claim an applicable Securities Act exemption. If, alternatively, ICO tokens are not securities, then all of those requirements fall by the wayside. Experts try to read the tea leaves coming from the SEC on this front, while typically falling back on the classic 1946 Supreme Court case of SEC v. W.J. Howey Co. to guide the analysis, even as opinions on the implications of that case for specific ICO tokens remain divided. Because CAM and Enneking settled with the SEC, the order does not analyze in detail exactly which digital assets constituted securities. But the SEC’s finding of an ICA violation indicates that such security-type tokens must have made up at least 40% of CAF’s holdings, suggesting that it is common for ICO tokens to qualify as securities. Indeed, the SEC may have intentionally omitted a detailed analysis of which tokens were and were not securities so as to send a message to other managers of crypto funds that any of their holdings could be subjected to similar scrutiny in the future.
Part III – Compliance Analysis
The compliance implications of the Commission’s decision are also considerable. In the announcement, the SEC states that both CAM and Enneking failed to register with the Commission in any way, neglected to register as an investment company or qualify under any applicable exemptions, and that CAM did not seek an order from the Commission providing it with exemptive relief. While the SEC does not analyze what went wrong in CAM’s decision making process, CAM apparently made no attempt to determine the appropriate regulatory structure under which it was operating. CAM failed to abide by the laws governing securities offerings, as well as the regulations promulgated under the Investment Company and Investment Advisers Acts. From the Commission’s perspective, investing in certain types of digital assets requires registration and puts the asset manager squarely under the guidelines of the Investment Company Act and the Investment Advisers Act. Accordingly, asset managers wishing to pool collective funds for investment need an orderly process of decision making including consulting with the appropriate legal and compliance experts regarding securities offering regulations, determinations regarding registration or exemptions under the Investment Company Act, registration with the SEC or individual states under the Investment Advisers Act (or state equivalents), and the building of an appropriate compliance structure. Given the volatility of digital assets, it seems particularly important to pay attention to compliance matters in order to provide assurance to regulators, vendors, investors, and allocators that you are closely observing the relevant details.
Part IV – Implications
With the CAM announcement, the SEC has taken another step in the maturation process of the regulation of digital assets. With the issuance of the DAO Report in 2017, the pronouncements of various senior SEC officials in 2018, and now the announcement In re Crypto Asset Management, LP, the Commission has decisively confirmed the direction many of us saw them headed – toward tighter regulation that fits these new assets squarely into existing categories of regulation. The good news for the rest of us is that we now know more about how the SEC understands things and intends to proceed. The wild west seems to be ending, but there are opportunities in abundance for those disciplined enough to follow the rules.
About the Authors
Randy Heinig is the Founder and Managing Director of Risk Compliance Analytics, which provides boutique compliance services to small and emerging asset managers. He can be reached at rjheinig@riskcomplianceanalytics.com.
Zach Ziliak is the Founder and Managing Member of Ziliak Law, LLC, a Chicago-based law firm that provides legal services to fund managers and financial industry participants from investment advisers to commodity pool operators. He may be reached at zachary@ziliak.com.