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The regulatory landscape for financial service companies and investment firms is complex and requires careful analysis of rules and regulations promulgated by several governmental authorities. For sponsors of funds in the U.S. investing in cryptocurrencies or digital assets, the regulations enforced by the Commodity Futures Trading Commission (CFTC) and the Securities Exchange Commission (SEC) are of primary importance. This article provides a primer on certain CFTC and SEC regulations that apply to investment funds and fund managers implementing an investment strategy involving Bitcoin, Ether and other digital assets.

This article seeks to answer basic questions about operating a cryptocurrency fund, such as:

  • How will my crypto fund be regulated?
  • Do I need to register my crypto fund with the SEC or CFTC?
  • Do I need to register as an investment adviser?

            SEC Regulation of Digital Asset Investment Funds

            The Securities Act of 1933 (the “Securities Act”) regulates the offer and sale of securities, including the offering of interests – e.g. LP interests, LLC units, or shares – in an investment company. The Securities Act requires an issuer to register an offering of securities absent an exemption. An offering conducted pursuant to an exemption is commonly referred to as a private or exempt offering. The most common exemption from registration used by issuers that qualify as investment companies is Rule 506(c) of Regulation D, which permits an issuer to raise an unlimited amount of funds from investors. This rule also permits the issuer to generally solicit purchase of its securities by advertising the offering.

            Investment Company Act Limitations

            The Investment Company Act of 1940 (the “1940 Act”) is a broad statute that imposes exacting requirements on registered investment companies, including control, capital, and operational requirements, among others. The 1940 Act mandates registration for “investment companies” – any issuer that “is or holds itself out as being engaged primarily, or proposes to engage primarily, in the business of investing, reinvesting or trading in securities.” (Section 3(a)(1)(A)). This test is designed to regulate companies obviously acting as investment funds, and digital assets fund clearly meet this qualification.

In certain circumstances, whether a company qualifies as an investment company may be more ambiguous. This is because Section 3(a)(1)(C) offers a second definition for the term “investment company” known as the balance sheet test. Section 3(a)(1)(C) provides that a company falls within the definition of an “investment company” under the ICA if more than 40% of its total assets, determined on an unconsolidated basis, consists of “investment securities.” As a result of this rule, companies that do not intend to operate their businesses as investment companies may become inadvertent investment companies if they fail the ICA’s balance sheet test.

The question of whether a particular cryptocurrency constitutes an “investment security” must be addressed on a case-by-case basis. Although the SEC has taken the position that Bitcoin and Ether are not securities, the regulator has not yet made such determination regarding any other digital asset. Instead, the SEC has brought enforcement actions against companies it believes issued tokens as securities.

Based on this understanding, we believe a fund investing in Bitcoin and Ether only, will not be considered an investment company act under the ICA and, therefore, need not register as such with the SEC. But a fund using margin or leverage to invest in BTC or ETH may be required to register in some capacity with the CFTC.

To avoid the costly and time-consuming process of registering with the SEC as an investment company, a digital asset fund sponsor will benefit from structuring the fund as a private fund under one of two commonly used exemptions.

            The Private Fund Exemptions – 3(c)(1) and 3(c)(7) Funds

            The ICA provides certain exclusions from the definition of an “investment company.” It also provides two exemptions commonly used by hedge funds and private equity funds. Funds structured in accordance with Section 3(c)(1) or Section 3(c)(7) are referred to as private funds.

            Section 3(c)(1) of the ICA exempts from registration any issuer who meets the following requirements:

  • 99 Investor Rule: the issuer’s outstanding securities are beneficially owned by fewer than 100 persons (unless the fund is a “qualifying venture fund” with less than 10m in capital commitments then this number is 250 persons)
  • No Public Offering Rule: the issuer has not and will not offer the securities in a public offering

Section 3(c)(7) exempts any issuer that meets both of the following:

  • Qualified Purchaser Rule: the issuer sells securities exclusively to qualified purchasers:
  • individuals owning more than $5m in investments, excluding a primary residence a person not less than $5 million in investments;
    • a company with not less than $5 million in investments owned by close family members;
    • a trust, not formed for the investment, with not less than $5 million in investments;
    • an investment manager with not less than $25 million under management;
    • a company with not less than $25 million of investments; and
    • a company owned by qualified purchasers.
  • No Public Offering Rule: the issuer has not and will not offer the securities in a public offering

Most private equity funds and hedge funds utilize one of these two exemptions. Persons forming a digital asset fund should be sure to consider the both exemptions in light of their investment strategy, as registering an investment company with the SEC is a burdensome process and will subject the fund significant, on-going compliance requirements.

            SEC Regulation of Digital Asset Investment Fund Managers

The Investment Advisers Act of 1940 governs advisers to investment companies. Specifically, Section 202(a)(11) of the Advisers Act, requires a person to register as an investment adviser if he or she “for compensation, engages in the business of advising others, either directly or through publications or writings, as to the value of securities or as to the advisability of investing in, purchasing, or selling securities”, or “for compensation and as part of a regular business, issues or promulgates analyses or reports concerning securities.”

The key question then is whether the Fund’s assets include securities. If they do not, then the Fund manager will not be required to register.

            Private Fund Adviser Exemption

            If a fun will invest in digital securities, the investment manager must register with the SEC unless it qualifies as an exempt reporting adviser. The exempt reporting adviser exemption is subdivided into two categories of exemptions: (1) the Private Fund Adviser Exemption and (ii) the Venture Capital Fund Adviser Exemption.

            Under the private fund adviser exemption, U.S. advisers managing only private funds and having less than $150 million in regulatory assets under management (“AUM”) will generally be exempt from SEC registration. Assets managed from a location outside the U.S. will not count towards the $150 million limit.

            The venture capital adviser exemption applies to advisers to “venture capital funds,” defined as any private fund that:

 (1) represents to investors that it pursues a venture capital strategy;

(2) immediately after the acquisition of any asset, other than qualifying investments or short-term holdings (as defined in the rule), holds no more than 20% of the amount of the fund’s aggregate capital contributions and uncalled committed capital in assets (other than short-term holdings) that are not qualifying investments, valued at cost or fair value, consistently applied by the fund;

(3) does not borrow, issue debt obligations, provide guarantees or otherwise incur leverage in excess of 15% of the private fund’s aggregate capital contributions and uncalled committed capital, and any such borrowing, indebtedness, guarantee or leverage is for a nonrenewable term of no longer than 120 calendar days, except that any guarantee by the private fund of a qualifying portfolio company’s obligations up to the amount of the value of the private fund’s investment in the qualifying portfolio company is not subject to the 120 calendar day limit;

(4) only issues securities the terms of which do not provide a holder with any right, except in extraordinary circumstances, to withdraw; and

(5) is not registered under section 8 of the Investment Company Act and has not elected to be treated as a business development company pursuant to section 54 of the Investment Company Act.

An exempt reporting adviser must file Form ADV within 60 days of the date on which the firm commences its advisory relationship with its first client.

            Ensuring a fund and its manager complies with relevant securities and commodity law is the first step in creating a successful cryptocurrency fund. Investment managers implementing digital asset investment strategies also should take care to provide appropriate disclosures and risk factors in their offering memorandum and carefully devise an appropriate legal structure suited to their investor pool.

Bull Blockchain Law LLP is a law firm focused on advising blockchain technology companies and digital asset funds. If you have questions about digital asset fund formation, operation, and compliance matters contact