On September 11, 2018, the Securities and Exchange Commission issued a cease-and-desist order and a $200,000 penalty to Crypto Asset Management LP (“CAM”) and its founder, Timothy Enneking. The SEC’s cease-and-desist order is available here. CAM and Enneking settled the matter on a without admitting or denying basis. The SEC’s action is an important reminder for pooled investment funds to be mindful of applicable federal securities laws when organizing and structuring their operations.
According to the SEC’s order, CAM manages digital cryptographic and related assets for institutional investors and high net-worth individuals. At the end of 2017, CAM had more than $37 million in assets under management. In August 2017, CAM launched Crypto Asset Fund, LLC (“CAF”), a hedge fund investing in cryptographic digital assets. Over a four-month period, CAM raised more than $3.6 million for CAF from 44 investors, primarily individuals, residing in at least 15 states.
The SEC found that CAM violated Sections 5(a) and 5(c) of the Securities Act of 1933 (the “Securities Act”) by offering and selling unregistered securities and failing to comply with relevant requirements for an exemption under Rule 506(b).
The SEC also found CAM caused CAF’s operation as an unregistered investment company in violation of Section 7(a) of the Investment Company Act of 1940 (the “Investment Company Act”). According to the SEC’s order, CAF met the definition of “investment company” under Section 3(a)(1)(C) of the Investment Company Act because it was engaged in the business of investing, holding, and trading certain digital assets that were investment securities (as defined in Section 3(a)(2) of the Company Act), having a value exceeding 40% of the value of CAF’s total assets (exclusive of government securities and cash items).
Moreover, the SEC found that CAM and Enneking negligently misrepresented to actual and prospective investors in certain marketing materials that CAF was the “first regulated crypto asset fund in the United States” and had filed a registration statement with the SEC. The SEC concluded that CAM and Enneking violated Section 17(a)(2) of the Securities Act, and Section 206(4) of the Investment Advisers Act of 1940 and Rule 206(4)-8 thereunder.
The SEC’s order recognizes that, after being contacted by SEC staff, CAM ceased its public offering of CAF’s interests and undertook a review of CAM’s website, marketing materials, and offering procedures. CAM and Enneking also disclosed their previous misstatements and offered buy backs to the existing investors. In January 2018, CAM and Enneking began to offer securities pursuant to the Regulation D Rule 506(c) exemption.
According to the SEC, this is its first case concerning an investment company violation by a hedge fund manager based on its investments in digital assets. Growing interest in blockchain and the digital asset industry has led to the inception and rapid growth of numerous cryptocurrency and digital asset investment funds targeting investors seeking exposure to the new asset class. The CAM action represents another expansion of the SEC’s enforcement activities in the digital asset marketplace.
The CAM action is an important reminder for pooled investment funds to be mindful of applicable federal securities laws when organizing and structuring their operations. Through speeches and enforcement actions, the SEC and its Staff have expressed views about when digital assets are investment securities. It is prudent for funds that purchase, hold, and sell digital assets to analyze whether those digital assets are securities, as part of efforts to comply with the federal securities laws applicable to investment funds, including the Investment Company Act.
Most private funds are structured to satisfy the exemptions from the definition of an “investment company” in Section 3(c)(1) or 3(c)(7) of the Investment Company Act. Both exemptions, generally referred to as the “private fund” exemptions, require the fund to refrain from making a public offering of its securities and limit the scope of potential investors in the pooled structure. Specifically, Section 3(c)(1) limits the investment fund to no more than 100 total investors, while Section 3(c)(7) requires a fund to limit their investors to “qualified purchasers.” Qualified purchasers is a narrow category of investors which includes prospective investors that meet certain minimum asset thresholds (usually either minimum holdings of $5 million in investments for individuals and certain entities owned by close family members or $25 million for entities, including institutional investors).
In addition to the Investment Company Act exemptions highlighted by the CAM action, pooled digital asset investment vehicles should also consider compliance with other applicable federal and state securities laws, including:
- Compliance with Rule 506 of Regulation D under the Securities Act when offering interests in the pooled vehicle to potential investors;
- Compliance with applicable state “blue sky” law depending on where offerees reside and/or sales occur;
- Compliance with broker-dealer regulations under the Securities Exchange Act of 1934, particularly in light of the contemporaneous enforcement action against the digital asset promoter TokenLot, LLC (discussed in our prior client alert that may be found here);
- Compliance with the Advisers Act (including registration as an investment adviser or filing as an exempt reporting adviser) and state securities laws regulating investment advisers;
- State regulation of blockchain and digital asset technology, such as the recent framework implemented by the New York Department of Financial Services; and
- Anti-money laundering, OFAC sanctions, and other regulatory regimes implemented by the U.S. Department of the Treasury.
As SEC scrutiny of the blockchain and digital asset marketplace increases, managers of pooled vehicles investing in such assets should evaluate and monitor the evolving regulatory landscape and undertake appropriate legal compliance measures.