Funds Talk: May 2018
Legal commentary on the news and events that matter most to alternative asset managers and funds.
Topics covered in this issue include:
- OCIE Warns Advisers to Check Fee and Expense Compliance After observing several issues during its routine inspections, the SEC’s Office of Compliance Inspections and Examinations issued a risk alert outlining the most common shortcomings so that advisers can ensure their practices are compliant.
- SEC Proposes Enhanced Investment Adviser and Broker-Dealer Standards of Conduct Citing “investor confusion” with regard to broker-dealers and investment advisers, the SEC issued three proposals outlining standards of conduct that seek to protect and inform retail investors while improving disclosure practices — particularly regarding potential conflicts of interest.
- The Rise of the #MeToo Movement: An Opportunity, Not an Obligation The #MeToo movement has raised difficult discussions in offices across the U.S., but rather than shying away from the conversation, companies should understand that embracing this cultural shift isn’t only good business — it’s the right thing to do.
- Supreme Court Rules Microsoft Case Moot as CLOUD Act Becomes Law Recent updates to U.S. legislation governing data privacy and government surveillance substantially alter digital service providers’ obligations, and the changes have already had an impact on a high-profile case before the Supreme Court.
- LIBOR Replacement Begins Publication As the New York Federal Reserve Bank launched its Secured Overnight Financing Rate as its alternative to LIBOR, a new report details the transition period and the pursuit of a baseline level of liquidity for derivatives contracts using the new rate.
- OFAC Issues Cryptocurrency Compliance Guidance Continuing the approach taken by various U.S. agencies and market regulators, OFAC advises that entities face the same compliance obligations for transactions denominated in virtual currencies as they do for traditional currencies.
- Tax and Cryptocurrencies Despite the meteoric rise of cryptocurrencies, the IRS has issued minimal guidance on the issue. Nonetheless, investors must be aware of the significant tax considerations associated with buying and selling these virtual currencies.
OCIE Warns Advisers to Check Fee and Expense Compliance
On April 12, 2018, the Securities and Exchange Commission (SEC) issued a risk alert outlining certain compliance issues identified by the regulator’s Office of Compliance Inspections and Examinations (OCIE) related to advisory fee and expense compliance.
The issues detailed in the alert were those most frequently identified by OCIE in deficiency letters sent to SEC-registered investment advisers as part of its examination program. By highlighting the most commonly encountered shortcomings, OCIE encouraged advisers to review their practices, policies and procedures to ensure compliance with their advisory agreements and representations to clients regarding fees and expenses made in Form ADV and other disclosures. Further, OCIE reminded advisers that failing to do so may violate the Investment Advisers Act of 1940 (the Advisers Act) and related rules, including its anti-fraud provisions.
View PDF version here.
Most Frequent Compliance Issues
The most frequently identified deficiencies related to advisory fees and expenses include:
- Fee-Billing Based on Incorrect Account Valuations – OCIE observed advisers assigning incorrect values on clients’ assets, which resulted in incorrect advisory fees in instances where fees are calculated as a percentage of the value of assets managed. This has included miscalculating assets by using a different metric or process than that described in the client’s advisory agreement.
- Billing Fees in Advance or With Improper Frequency – Among the examples observed by OCIE staff were advisers billing fees on a monthly basis, rather than the quarterly basis stated in the advisory agreement or in Form ADV Part 2; advisers billing advisory fees in advance, despite representing to clients they would be billed in arrears; advisers billing a new client in advance for an entire billing cycle, instead of prorating fees for advisory services that began mid-billing cycle; and advisers failing to reimburse to a client a prorated portion of their advisory fees when the client terminated the advisory services mid-billing cycle, despite disclosing that they would do so in Form ADV Part 2.
- Applying Incorrect Fee Rate – Advisers were observed, for example, applying a rate higher than what was outlined in the advisory agreement, double-billing clients or charging a nonqualified client a performance fee based on a percentage of their capital gains inconsistent with Section 205(a)(1) of the Advisers Act.
- Omitting Rebates and Incorrectly Applying Discounts – OCIE staff observed advisers failing to apply rebates or discounts as specified in advisory agreements, including not combining account values for clients in the same household, when doing so would have resulted in discounted fees; failing to reduce a client’s fee when their account reached a specified threshold that should have resulted in a lower fee; and charging additional fees, such as brokerage fees, to wrap fee program clients who qualified for the program’s bundled fee.
- Disclosure Issues Involving Advisory Fees – For example, certain advisers’ actual practices were inconsistent with those outlined in their Form ADV disclosures, such as charging an advisory fee rate higher than the disclosed maximum rate or not disclosing certain fees or markups in addition to their advisory fees, such as those from third-party execution and clearing services.
- Adviser Expense Misallocations – Certain advisers to private and registered funds were observed misallocating expenses to the funds they advise, including allocating distribution and marketing expenses, regulatory filing fees, and travel expenses to clients instead of the adviser, in contradiction of the advisory agreement, operating agreements or other disclosures.
How to Respond
In response to these observations, OCIE staff reported that some advisers elected to “change their practices, enhance policies and procedures, and reimburse clients by the overbilled amount of advisory fees and expenses,” while others “proactively reimbursed clients for incorrect fees and expenses that they identified through the implementation of policies and procedures that provided for periodic internal testing of billing practices.” All advisers should take the opportunity to reassess their own advisory fee and expense practices and related disclosures to confirm their compliance with the Advisers Act and all related rules and responsibilities, and also review the adequacy and effectiveness of their compliance programs.
SEC Proposes Enhanced Investment Adviser and Broker-Dealer Standards of Conduct
On April 18, the Securities and Exchange Commission (SEC) proposed a trio of rules and interpretations designed to enhance the quality and transparency of investors’ relationships with investment advisers (IAs) and broker-dealers (BDs) while preserving access to a variety of types of advice relationships and investment products.
The three proposals included Proposed Regulation Best Interest, Proposed Investment Adviser Interpretationand Proposed Form CRS Relationship Summary. Overall, the SEC indicated that the proposed rules and interpretations “would enhance investor protections by applying consistent principles to investment advisers and broker-dealers,” including providing clear disclosures, exercising due care and addressing conflicts of interest. The SEC also clarified that IAs’ and BDs’ specific obligations would be “tailored to the differences in the types of advice relationships that they offer.”
Proposed Regulation Best Interest
The first proposed rule would create a standard of conduct for any BD or person associated with a BD who recommends securities transactions or investment strategies involving securities to a retail customer. That standard of conduct includes a duty “to act in the best interest of the retail customer at the time the recommendation is made, without placing the financial or other interest of the broker-dealer ahead of the retail customer” and is similar to the Department of Labor’s fiduciary rule, which the 5th Circuit Court of Appeals vacated in March.
Essentially, the SEC’s Regulation Best Interest codifies the principle that a BD may not put its financial interests ahead of those of a retail customer while making recommendations. The proposed rule outlines specific obligations that must be satisfied for compliance:
- Disclosure: The covered entity must disclose in writing to the customer all material facts about the relationship, including associated conflicts of interest.
- Diligence and Care: The BD must “exercise reasonable diligence, care, skill, and prudence” to (i) understand the recommended product, (ii) have a reasonable basis to believe that the product is in the customer’s best interest and (iii) have a reasonable basis to believe that a series of recommended transactions is in the retail customer’s best interest in the context of their overall investment profile.
- Conflict of Interest: The covered entity is required to establish, maintain and enforce written policies and procedures reasonably designed to identify and to disclose or eliminate all material conflicts associated with the recommendations.
Proposed Form CRS Relationship Summary
Under the second proposed rule, IAs, BDs and their respective associated persons would be required to provide retail investors a summary outlining information about the relationships and services the firm offers, the fees and costs associated with those services, specified conflicts of interest, and whether the firm and its financial professionals have any reportable legal or disciplinary events. The SEC intends the Form CRS (Customer/Client Relationship Summary) to provide clarity for investors so they understand both “who they are dealing with” (i.e., an IA, a BD or a “dual-hatted” entity) and “what that means and why it matters.” This includes a two-pronged approach:
- Clear Labeling: Requires BDs and IAs to be direct and clear about their legal form in communications with investors and prospective investors. In addition, stand-alone BDs and their financial professionals would be restricted from using the terms “adviser” and “advisor” as part of their names or title, as the SEC states they are so similar to “investment adviser” that their use by a stand-alone BD may mislead prospective customers.
- Fee, Conflict and Other Material Disclosure: Requires IAs, BDs and dual-hatted entities to provide investors with a standardized, short-form disclosure. At a maximum length of four pages, the disclosure must highlight important differences in the types of services offered, the legal standards of conduct that apply to each, any customer fees and conflicts of interest that may exist. It will also inform customers how to get more information, including on the firm’s or investment professional’s disciplinary history.
The SEC also released three Form CRS mock-ups to help IAs, BDs and retail customers visualize how they would look, providing examples of potential disclosures for stand-alone BDs, stand-alone IAs and dually registered firms.
Proposed Investment Adviser Interpretation
Finally, the SEC proposed interpretation of the standard of conduct for IAs under the Investment Advisers Act of 1940, with the intent of reaffirming and clarifying certain aspects of their fiduciary duties in light of the “comprehensive nature” of the two accompanying proposed rules. Overall, the interpretation states that “[a]s fiduciaries, investment advisers owe their clients a duty of care,” including (i) the duty to act and to provide advice in the best interest of the client, (ii) the duty to seek best execution of a client’s transactions where the adviser has the responsibility to select BDs to execute client trades, and (iii) the duty to provide advice and monitoring over the course of the relationship. The interpretation also outlines an IA’s duty of loyalty requiring it “to put its client’s interests first,” which includes providing “full and fair disclosure … of all material facts relating to the advisory relationship,” such as any potential conflicts of interest.
The SEC is accepting public comment on all three proposals, and the comment period will remain open for 90 days following publication of the documents in the Federal Register.
The Rise of the Me Too Movement: An Opportunity, Not an Obligation
Undoubtedly, the No. 1 topic in the employment world today is sexual harassment and the rise of the #MeToo movement. Indeed, it is one of the top issues in American society generally, touching all industries. With new allegations making headlines at a shocking rate, a spotlight has been cast on the culture of the American workplace – and employers’ reactions to these events – leaving employers uneasy about how to proceed. But rather than feeling anxious about these developments, employers should recognize that this is a time of opportunity that can bring about dramatic and positive changes for both employers and employees.
The advent of the #MeToo movement and the resulting national conversation about the American workplace give employers the opportunity to positively and clearly redefine the boundaries of acceptable workplace conduct and to expand the channels of communication with employees. At this moment, employers are uniquely positioned to send a message to their employees that they are valued and that the employer is committed to providing a respectful workplace — not merely because the employer wishes to mitigate legal risk or prevent a PR disaster, but because it is the right thing to do. But improving workplace culture and addressing workplace harassment are more than ethical imperatives; they also are good for business. A respectful workplace, in which discrimination and harassment are prohibited, demonstrably increases employee productivity, reduces the costs of absenteeism associated with harassment and enhances retention of valued employees. Moreover, employers with respectful workplace cultures can expect increased job satisfaction and organizational commitment by their personnel.
While many employers have generic anti-discrimination and harassment policies stating they do not tolerate illegal discrimination or harassment, a more robust approach is necessary. This article addresses practical steps employers can take to reap great benefits not just for employees and the company, but for the broader American society as well.
Secure Tangible Buy-In From Senior Management
While human resources and legal teams are valued partners, the senior leadership of the business has the clout to convey to employees the boundaries of acceptable workplace conduct. Accordingly, it is imperative to secure buy-in from senior management on the company’s workplace behavior policies and ensure that all managers understand and accept their responsibility to serve as standard bearers for the company by modeling professional and respectful conduct.
Senior management can further demonstrate that professional workplace behavior is a core value by attending and supporting trainings on the subject. At a recent workplace conduct training, the CEO demonstrated his support for the company’s respectful culture by (1) personally sending the invitation for the training to all managers, (2) introducing the presenter and noting the importance of the training, and (3) staying for the entire presentation. His actions made clear that the employer valued the policies emphasized in the training and that it was not merely intended to satisfy a compliance requirement.
Beyond training, senior management can convey the importance of anti-harassment policies by devoting appropriate resources for investigations and taking appropriate disciplinary action when misconduct or retaliation is discovered, regardless of how high-ranking the wrongdoer is, how much revenue he or she brings in, or whom she or he knows in the C-suite. Holding everyone accountable and to the same standards will reassure all employees that their complaints will be taken seriously, and will empower human resources personnel by making clear that their recommendations will be fairly evaluated and followed where appropriate. Along these lines, to ensure that HR professionals provide sound recommendations to the businesses they support and that they command the respect of senior management and the employees with whom they interact, it is critical that HR professionals be well-trained.
Workplace Behavior Policies: Focus Broadly, Educate Practicably, Enforce Proactively
Broaden the Focus of Workplace Behavior Policies
More than ever, workplace behavior policies must foster a culture where everyone is treated with respect and civility, rather than simply prohibit discriminatory conduct. We suggest that workplace behavior policies be broadened in furtherance of this goal as follows:
- Include Provisions That Require Respect in the Workplace and in Professional Conduct: Although most employee handbooks address explicitly harassing conduct prohibited by law, companies should consider broadening policies to prohibit uncivil behavior beyond just that prohibited by the law. Examples of inappropriate behavior that should be banned may include lewd, profane or abusive language; yelling at another person; threatening or using intimidation; discussions of employees’ sex lives; and any other conduct that undermines the integrity of the working relationship.
- Expand Reporting Procedures: While most employers provide employees with a procedure for reporting violations of misconduct, they are often limited to complaining to human resources or a direct manager. But an employee may not feel comfortable reporting to an HR professional with whom she or he may have had little interaction or from whom he or she may fear retaliation for reporting to a manager. As a result, the employee may not raise his or her complaints. To avoid this pitfall, consider expanding reporting procedures to include multiple possible avenues, such as various levels of management, human resources staff, the legal department and/or a trained ombudsman.
- Liability and Responsibility for Out of Office Conduct: While legal and HR professionals are well aware that employers and employees may be responsible for out-of-office conduct when employees are with their colleagues, managers, subordinates, clients and vendors, employees are often surprised by this fact, defending themselves by saying, “But I wasn’t in the office” or “We were out for drinks after work.” Policies should be clear that violations can occur at business meetings, business meals or private sites, wherever employees and business affiliates meet.
- Consider Adopting an Intracompany Relationships Policy: While not every workplace relationship needs to be banned, and, of course, no employer wants to stand in the way of true love, it is important to be cognizant of the risks associated with permitting romantic relationships between employees. This is particularly true in relationships in which one employee is in a supervisory role, which creates a power imbalance and could be viewed by the subordinate and/or an adjudicator as inherently coercive. Employers should consider adopting an intracompany relationship policy and weigh the merits of banning or placing constraints on relationships between supervisors and subordinates. For example, some companies prohibit employees within a reporting line from engaging in a relationship or require employees to report relationships with potential conflicts of interest. Other companies institute rules that forbid employees from asking an employee out on a date if they are turned down the first time.
- Bolster Requirements for Reporting Abuses: While managers are required to report any harassing conduct they witness, most policies simply “suggest” or “urge” nonsupervisory employees to report harassing conduct regardless of whether they are targets of such conduct but do not require them to do so. Consider shifting the focus of such policies to requiring bystanders to report conduct. Emphasize the positive and career development opportunities that could spring from voluntarily coming forward. To convey the importance of this policy, consider adding a section to formal written performance reviews to evaluate an employee’s role as a “culture carrier” and his or her contribution to fostering a respectful work environment.
An employer may have robust, thoughtful policies prohibiting harassing and uncivil conduct, but the policies are irrelevant if employees do not understand or do not follow them. We have all witnessed the classic harassment training scenario in which policies and hypotheticals are presented on PowerPoint slides while participants compulsively check email or play games on their cellphones, or click through self-guided online training while on a call or listening to a podcast (or worse, asking someone else to do it for them) without absorbing the content. The thought is often “I’m not going to sexually harass anyone, so why is this training relevant to me?” To seriously shift workplace culture in a positive direction, employees need to understand that they play a critical role in policing the boundaries of workplace culture.
To maximize employee engagement in harassment training, the training should be live and interactive, mandatory for managerial employees, and considered for non managerial personnel (to ensure appropriate workplace culture permeates the entire workforce). Cellphone use should be discouraged, and senior leadership should attend the sessions to emphasize the company’s commitment.
Be Proactive; Avoid Stepping Into Other Legal Claims
Vice President Mike Pence purportedly maintains a policy of not eating alone with women other than his wife and not attending events without her. Reportedly, throughout his time in Congress, he required that any aide working late with him had to be male. The immediate reaction of some male managers who fear a sexual harassment claim may now be to utilize the “Pence Rule.” However, condoning the Pence Rule by permitting male supervisors to avoid one-on-one meetings with female subordinates or taking them to client dinners or other meetings to prevent harassment claims could lead to claims of gender discrimination. Such conduct could also lead an employer to miss out on opportunities to develop and promote talented female employees to the detriment of the business, ultimately resulting in the departure of valued female employees. Employers must specifically address this subject in training and prohibit such practices. Moreover, employers should be proactive and check in with female employees on a regular basis, using mechanisms such as voluntary focus groups or women’s initiative committees to make sure female employees feel they are receiving appropriate opportunities.
Handle Complaints Proportionally and Follow Up Promptly After Resolution
While employers hope to foster a workplace free of sexual harassment, they must be prepared to address complaints when they arise. An appropriate and prompt response can meaningfully enhance workplace culture, resulting in an environment where employees feel more comfortable raising concerns when they first arise and increasing the likelihood that they will remain employed following such complaints.
In light of the extreme publicity that sexual harassment claims are receiving, it is understandable that employers might believe that any discipline short of termination may be perceived as too weak a response. However, such an extreme position may discourage bystanders or alleged victims from reporting minor abuses for fear of getting the alleged wrongdoer fired, and it could result in the loss of talented employees who may have made a “minor” mistake. Consider a female employee whose male supervisor has made several comments in the workplace objectifying the bodies of female actresses and models. The two have a solid working relationship, but his comments bother her, and she would like them to stop. If the employer is known for firing every employee accused of engaging in any wrongful conduct, this complaint may never be reported or may be reported only in the context of more egregious harassment down the road. In the meantime, the productivity of the female employee and her team may decline or, worse, that female employee may just choose to resign. Where employees feel comfortable that the “punishment” fits the “crime,” they will feel more comfortable raising their concerns.
Moreover, some complaints clearly lack merit or sufficient evidence. In such instances, employers should be prepared to state that the claims are uncorroborated or unfounded. Failing to do so will harm innocent employees and damage the credibility of employees with valid claims, and it may even expose the employer to legal risk.
Once an investigation concludes, employees who complain or participate in an investigation must move forward, but doing so can be awkward. A simple action employers can take to advance a culture in which employees feel comfortable raising complaints and participating in investigations is to have HR and/or participating managers follow up with alleged victims and bystanders at regular intervals after the close of the investigation. Making sure these employees are comfortable in their work environment helps strengthen an employer’s commitment to its anti-retaliation policy in a visible way and will reassure other employees afraid to come forward or participate.
The culture of the American workplace is inevitably changing. Employers can either embrace the opportunity to be the voice behind the change, or reluctantly accept the obligation to comply as it is forced upon them. A workplace that is grounded in respect for colleagues, renounces all forms of offensive and unprofessional conduct, and supports open lines of communication between employer and employee is not only the most legally compliant environment, but also the most beneficial for the business.
Supreme Court Rules Microsoft Case Moot as CLOUD Act Becomes Law
The Clarifying Lawful Overseas Use of Data Act (CLOUD Act) was recently signed into law as part of the omnibus appropriations bill.
Generally, the CLOUD Act updates U.S. data privacy and government surveillance laws, enacted in 1986, to better reflect current technology and practices – particularly concerning cloud computing, which involves remote data storage, often on overseas servers. The CLOUD Act requires U.S. electronic communications and remote computing service providers that are served with court orders, warrants or subpoenas under the Stored Communications Act (SCA) to turn over data in the provider’s possession, custody or control – no matter where the data is stored (although providers have the ability to petition to modify or quash such orders under certain conditions).
In light of the CLOUD Act’s passage, the U.S. Supreme Court ruled on April 17 that United States v. Microsoft– a highly publicized case addressing the government’s ability to access data stored abroad pursuant to warrants under the SCA served on U.S. providers – had become moot. The company was seeking to prevent U.S. law enforcement officials from exercising a warrant to access a user’s data as part of a drug trafficking investigation, since the data was stored on a server in Ireland. The actual residency or citizenship of the data user was unknown to Microsoft at the time it received the subpoena. The U.S. Court of Appeals for the Second Circuit had previously held that the SCA lacked exterritorial reach, leading the government to appeal the decision to the Supreme Court.
Section 105 of the CLOUD Act also creates a framework to allow the U.S. government to enter into so-called executive agreements with other countries that would permit U.S. providers to respond to those other countries’ requests for data. Executive agreements are subject to the approval of both the attorney general and the secretary of state, and can be rejected by Congress.
The CLOUD Act also formalizes the process for providers to modify or quash a law enforcement request in cases where data is stored in a country with which the U.S. has an executive agreement. Generally, where an executive agreement exists, a provider has 14 days to challenge an SCA warrant, which it may do on the grounds that it “reasonably believes” the affected “customer or subscriber is not a U.S. person and does not reside in the U.S.” and that the disclosure of the data would “create a material risk that the provider would violate the laws” of the foreign country. A court can approve such a challenge if it determines that disclosure would violate the laws of the foreign government; that modifying or quashing the legal process is in “the interests of justice”; and that “the customer or subscriber is not a U.S. person and does not reside in the U.S.” In instances where no executive agreement exists, a warrant can be challenged through a common-law comity analysis, looking at a variety of factors, including the significance of the requested information; the particularity of the request; and the interests of the affected foreign government, the entity seeking the disclosure and the U.S. itself.
Finally, in response to privacy and civil liberty concerns, the CLOUD Act contains certain limits and restrictions on data requests, such as allowing the U.S. government to enter into executive agreements only with countries that exhibit “robust substantive and procedural protections for privacy and civil liberties” and that will “minimize the acquisition, retention, and dissemination of information concerning United States persons.”
LIBOR Replacement Begins Publication
On April 3, the New York Federal Reserve Bank began publishing the Secured Overnight Financing Rate (SOFR), a daily, broad Treasury repo financing rate that the bank’s Alternative Reference Rate Committee (ARRC) recommended the adoption of last year as the alternative to LIBOR.
In its latest report, the ARRC acknowledges that the transition to SOFR will be difficult, given the volume of legacy contracts that reference LIBOR and do not have a fallback for its cessation. The ARRC observed that loan documentation typically implies that if LIBOR quotes are not published, the loan converts to an alternative base rate, such as the prime rate. However, because the prime rate is typically well above LIBOR, this would result in an unplanned and significant increase in borrowing costs.
The ARRC convened a working group to better understand the difficulties involved with the transition to SOFR and to conduct research into common forms of LIBOR-related contract language in the lending market. Working group members noted that loan contract language has begun to more robustly address economically appropriate fallbacks to LIBOR. The members also observed that there has been a movement by some market participants away from requiring unanimous consent of lenders to change the reference rate in syndicated loans.
View PDF version here.
The new report also provides for a paced transition plan to create a baseline level of liquidity for derivatives contracts referencing SOFR. The ARRC acknowledged that “end users cannot be expected to choose or transition cash products to a benchmark that does not have at least a threshold level of liquidity in derivatives markets.” The report lays out a transition plan, which concludes at the end of 2021 with the creation of a term reference rate based on SOFR derivatives. The intermediate steps are as follows:
- ARRC members will input infrastructure for overnight index swaps (OIS) and/or futures trading in SOFR in 2018.
- Trading in futures and/or bilateral, uncleared OIS that reference SOFR will take place by the end of 2018.
- In 2019, trading will begin in cleared OIS that reference SOFR in the current effective federal funds rate (EFFR) price alignment interest (PAI) environment.
- In 2020, central counterparties will begin allowing market participants a choice between clearing new or modified swap contracts in the current PAI/discounting environment or in one that uses SOFR for PAI and discounting.
- In 2021, central counterparties will no longer accept new swap contracts for clearing with EFFR as PAI and discounting.
The overarching goal of the paced transition plan is to progressively build the liquidity required to support the transition to and issuance of contracts referencing SOFR.
OFAC Issues Cryptocurrency Compliance Guidance
As part of the ongoing efforts of the federal government, agencies and financial market regulators to respond to the growing cryptocurrency market, the Office of Foreign Asset Control (OFAC) of the Department of Treasury recently added a “Questions on Virtual Currency” section to its Sanctions Compliance Frequently Asked Questions (FAQs).
View PDF version here.
OFAC’s responses to the FAQs (#559-563) effectively act as guidance on how its sanctions programs will scrutinize cryptocurrencies and related transactions, which have faced increased regulatory attentionfollowing a meteoric rise in popularity. Most notably, the FAQs state that U.S. persons or persons otherwise subject to OFAC jurisdiction engaged in transactions bear the same compliance obligations whether the transaction is denominated in cryptocurrency or traditional currency.
Generally, OFAC advises covered entities — “including firms that facilitate or engage in online commerce or process transactions using digital currency” — must ensure they “do not engage in unauthorized transactions prohibited by OFAC sanctions, such as dealing with blocked persons or property, or engage in prohibited trade or investment-related transactions,” including any transactions that successfully, or attempt to, evade, avoid or cause a violation of any OFAC-imposed prohibitions. Specifically, the FAQs instruct covered entities to ensure that they block the property and interests in property of anyone named on OFAC’s Specifically Designated Nationals and Blocked Persons (SDN List), or any entity owned in the aggregate, directly or indirectly, 50% or more by one or more blocked persons; and that they do not engage in trade or other transactions with such persons named on the SDN List, which identifies individuals and companies owned, controlled by or acting on behalf of targeted countries, as well as individuals, groups and entities, such as terrorists and narcotics traffickers. Additionally, OFAC instructs that persons providing “financial, material, or technological support for or to a designated person may be designated by OFAC under the relevant sanctions authority.”
OFAC’s FAQs continue to outline how it will extend the use of its existing authorities in response to the use of cryptocurrency and other emerging payment systems for illicit purposes, such as terrorism, malicious cyber activity and human rights abuses. It states that OFAC will use sanctions “as a complement to existing tools, including diplomatic outreach and law enforcement authorities,” and that it “may include as identifiers on the SDN List specific digital currency addresses associated with blocked persons” in order to strengthen its efforts under existing authorities.
SDN List Identifiers
Finally, the FAQs outline how OFAC will delineate information regarding cryptocurrencies on the SDN List. First, it states that OFAC “may add digital currency addresses to the SDN List to alert the public of specific digital currency identifiers associated with a blocked person.” As a result, those who identify digital currency identifiers or wallets they believe may be owned by or associated with an SDN “should take the necessary steps to block the relevant digital currency and file a report with OFAC that includes information about the wallet’s or address’s ownership, and any other relevant details.” In regard to the structure that digital currency addresses will take on the SDN List, the FAQs elaborate that the field will provide unique alphanumeric identifiers of up to 256 characters, and that the addresses will also identify the specific digital currency to which the address corresponds, such as Bitcoin, Ether or Litecoin.
Clients should take this guidance into account when implementing their compliance policies in this space. One lurking question not addressed in these FAQs is how firms should comply with these rules when their firm has been hacked and in order for the firm to regain access to its systems, the hacker requires the payment of cryptocurrency to an account that would constitute a violation of the OFAC rules.
Tax and Cryptocurrencies
The meteoric rise of cryptocurrencies has created a stir in the financial and investment communities. The Securities and Exchange Commission, along with other regulatory bodies, is taking an active role in policing and regulating this sphere. However, while cryptocurrencies raise myriad tax issues, some of which are discussed in this article, the Internal Revenue Service (the IRS) has issued only minimal guidance in the area.
Cryptocurrency is a decentralized digital cash system based on blockchain technology. New coins are typically “mined” by solving complex mathematical equations. Some of the more well-known currencies include bitcoin, Ethereum and Ripple. Cryptocurrencies are increasingly used as currency for purchases. For example, Overstock.com and Expedia accept payment with certain cryptocurrencies. Cryptocurrencies are not backed by any hard currency but can be converted to other currencies on certain trading platforms.
Cryptocurrencies are similar to other currencies in many ways because they are mostly used as a medium of exchange and a way to pay for goods and services. However, because cryptocurrencies lack a centralized governmental authority that issues and regulates them, it may not be appropriate to treat cryptocurrencies as currencies for tax purposes. An alternative way to view cryptocurrencies would be to treat them as property.
The IRS position
In Notice 2014-21 (the Notice), which was issued in 2014 and is the only cryptocurrency guidance from the IRS thus far, the IRS adopted the property model. Under that approach, use of cryptocurrency in a purchase or an exchange for another cryptocurrency is akin to a barter exchange. Similarly, the conversion of a cryptocurrency to dollars is treated as a sale of the cryptocurrency. All such transactions are taxable events in which gain or loss is recognized by the taxpayer exchanging the cryptocurrency. According to the Notice, the character of such gain or loss depends on whether the cryptocurrency is a capital asset in the taxpayer’s hands. The Notice also states that taxpayers who mine virtual currency realize income on the date of the receipt of cryptocurrency. Furthermore, taxpayers engaged in the trade or business of mining (but not as employees), receive ordinary income subject to self-employment tax when a coin is mined. Any payments in virtual currency are subject to information reporting and backup withholding.
The balance of this article follows the IRS position that cryptocurrency is property for income tax purposes.
A taxpayer’s basis in cryptocurrency generally is the cost (or, if acquired in exchange for other cryptocurrency or property, the fair market value) on the date of acquisition. Taxpayers should keep track of their basis and holding period in each specific unit of cryptocurrency acquired. When a taxpayer holds multiple lots of a cryptocurrency with different tax bases and sells only a portion of its position, when computing gain or loss from the sale it would be optimal for the taxpayer to be able to identify the specific lot that was sold (e.g., the lot with the highest tax basis). Absent specific identification, the IRS employs a first-in first-out (FIFO) system, which generally would result in the sale of low-basis lots in a climbing market. Because each crypto coin is coded and thus unique, arguably they are not fungible and thus specific identification should be available (much like if a taxpayers sold one of two chairs that it owns with different bases). However, as a practical matter, when such coins are held in a third-party wallet, it might not be possible for the taxpayer to establish which lot was sold. Thus, while Treasury regulations permit specific identification with respect to the sale of stocks, it is unclear that taxpayers may use such method in the cryptocurrency space.
The taxability of cryptocurrency transactions, such as trades of cryptocurrencies and the use of cryptocurrencies as a means of payment, raises difficult valuation issues. In order to determine the amount of gain or loss, the taxpayer must determine the fair market value of the cryptocurrency at the time of the relevant transaction. For some of the smaller or lesser-known cryptocurrencies, there might not be a sufficient market or trading volume for a taxpayer to be able to accurately determine the value of the cryptocurrency at any given time. While websites are available for the more well-known cryptocurrencies to keep track of values, such valuations may differ dramatically on any given day or at any time. Furthermore, because public trading platforms for virtual currencies are often open at all times, there is also no daily opening or closing price that a taxpayer can point to as the value to use in a transaction.
A hard fork in cryptocurrency occurs when the cryptocurrency is split into two or more currencies. An example is the split of bitcoin in August 2017 into bitcoin and bitcoin cash. In the fork, each bitcoin was split into one bitcoin and one bitcoin cash. After the fork, bitcoin and bitcoin cash have traded separately.
The treatment of a hard fork for tax purposes depends on whether the hard fork is a taxable realization event. Moreover, if it is a realization event, the timing and the amount of the taxable income must be determined.
One could argue that a hard fork should not be a realization event because the taxpayer, generally, has no control over and possibly no knowledge of the fork beforehand. Moreover, there is no accretion of wealth (the general test of income), because what the taxpayer held was simply split in two. Whether it is appropriate to impose a tax on a taxpayer in this circumstance is, at least in part, a policy question without a clear answer.
If a hard fork is not a realization event, the taxpayer does not recognize any taxable income upon receipt of the new cryptocurrency. However, it is unclear what basis the taxpayer should take in either or both cryptocurrencies. One possibility is that a taxpayer must split its pre-fork basis among the new cryptocurrencies received in the hard fork based on their relative fair market values. Alternatively, the taxpayer may retain the basis in the original cryptocurrency (e.g., the bitcoin retained in the bitcoin hard fork) and take a zero basis in the new cryptocurrency received (e.g., the bitcoin cash).
If a hard fork is treated as a realization event, on the premise that there has been an exchange that gave rise to accretion of wealth, it is not clear how to measure the gain. One approach would be to include in income the fair market value of the new cryptocurrency received (e.g., the bitcoin cash) without any offset for a portion of the taxpayer’s pre-fork basis. Another approach might be that the taxpayer must recognize gain or loss based on the difference between the fair market values of both cryptocurrencies received in the hard fork over the taxpayer’s pre-fork basis.
Administering and policing the reporting of cryptocurrency transactions are difficult for the IRS because of the ingrained anonymity of cryptocurrencies. The IRS has begun spending more resources on training staff on virtual currencies and dedicating some of its enforcement agents to virtual currency. Thus, enforcement and auditing for underreporting of cryptocurrency income appear to be a growing focus for the IRS.
For example, in the pending case United States v. Coinbase Inc., No. 3:17-cv-01431 (2017-98027) (N.D. Cal. Nov. 28, 2017), the IRS has issued a John Doe summons to Coinbase, a digital wallet platform. After rounds of negotiation, Coinbase has been ordered to turn over to the IRS information regarding users that have engaged in at least one transaction (buy, sell, send or receive) with a value of at least $20,000 during 2013-2015 for which Coinbase had not filed a Form 1099-K. (A Form 1099-K is used to report payments made in settlement of reportable transactions.) The IRS undoubtedly will use such information to seek out taxpayers who have not reported their cryptocurrency transactions.
This article touches on only some of the myriad tax issues involving cryptocurrencies. As cryptocurrencies develop and more guidance becomes available, the analysis of the tax consequences of such transactions undoubtedly will evolve as well.
 Terms such as “cryptocurrency,” “digital currency” and “virtual currency” are used interchangeably throughout this article.