In a regulatory first, the Securities and Exchange Commission (SEC) has issued a cease and desist order and imposed a $200,000 fine against a hedge fund that invested in digital assets and its founder. This is the first-ever enforcement action finding an Investment Company Act failure to register by a hedge fund manager based on the fund’s investments in digital assets.

To highlight the significance of this enforcement action, we have unpacked recent developments in the regulation of digital assets and the SEC’s views on these products.

A matter of jurisdiction: digital assets, tokens or cryptocurrencies?

The hedge fund manager involved in this case, Crypto Asset Management LP, served as the managing member and manager to Crypto Asset Fund LLC, a hedge fund formed for the purpose of investing in digital assets (Fund). While the Fund itself was formed to invest in digital assets, the SEC found that the Fund traded in “certain digital assets that were investment securities” within the meaning of the Investment Company Act of 1940, as amended, which is at the root of the enforcement action.

The distinction between non-security digital assets, cryptocurrencies and security tokens is not just a matter of semantics, and has significant consequences under the U.S. securities law. Set forth below is a summary that illustrates the differences between these terms:

  • Digital assets: In its simplest form, a digital asset is “simply code,” according to the SEC. This is a general term that refers to cryptocurrencies, coins, tokens, and any other text or media that is formatted into a binary source and includes the right to use it.
  • Cryptocurrencies: Not all cryptocurrencies are securities, but the SEC cautions that simply calling something a “currency” does not mean that it is not a security.
  • Tokens: Companies and individuals have sometimes used tokens or coins to raise capital for their businesses and projects, and many of these instruments have the key hallmarks of a securities offering. The test the SEC uses to determine whether a token is a security was established in the U.S. Supreme Court’s decision in SEC v. Howey Co., which indicates that a security is present where there is an investment of money in a common enterprise with an expectation of profit derived from the effort of others. The SEC found that the digital assets the Fund invested in were securities.

The enforcement case: noncompliant marketing and no Investment Company Act Exemption

In the Fund’s marketing materials, Crypto Asset Management represented to actual and prospective investors that the Fund was the “first regulated crypto asset fund in the United States” and had filed a registration statement with the SEC even though this was not true.

From Aug. 1, 2017, to Dec. 1, 2017, Crypto Asset Management raised more than $3.6 million from 44 investors through the use of its website, social media accounts and traditional media outlet interviews. It does not appear that Crypto Asset Management filed a registration statement for this offering with the SEC, nor does it appear that it verified the accredited status of investors that invested in the Fund as required under the Rule 506(c) private placement exemption. This exemption is permitted under Regulation D, Rule 506(c), and allows an issuer to publicly advertise and solicit an offering if, among other things, (i) the investors in the offering are all accredited investors and (ii) the issuer takes reasonable steps to verify that the investors are accredited investors, which could include reviewing documentation such as W-2s, tax returns, bank and brokerage statements, credit reports, and the like.

In addition, because more than 40% of the Fund’s assets were “investment securities” (as determined by the SEC), the Fund would be obligated to register with the SEC unless it could rely on an exemption from such registration. Based on the facts set forth in the settlement order, the exemption under Section 3(c)(1) of the Investment Company Act of 1940 would have been available to the Fund had it complied with Rule 506(c) of the Securities Act of 1933.

After being contacted by the SEC, the Fund ceased its public offering and offered to return the capital to the Fund’s investors. In connection with the rescission offer, the Fund also disclosed its previous misstatements to the affected investors and prospective investors. As of January 2018, Crypto Asset Management began offering interests in the Fund pursuant to Rule 506(c).

Crypto regulation tightens

The enforcement action shows continued regulatory interest in cryptocurrencies. The same day it issued this decision, the SEC issued a separate order against an unregistered crypto broker-dealer for violating similar regulatory requirements. The respondents in that case also agreed to pay a fine but did not admit to or deny the regulator’s findings.

This year, the SEC has repeatedly denied applications to recognize cryptocurrency ETFs. In a detailed decision issued in July, it rejected a proposal to list and trade shares of a bitcoin ETF over concerns about market manipulation. Soon after, it rejected nine other cryptocurrency ETF proposals in three separate orders.