Following the SEC’s recent commentary on Initial Coin Offerings, some investment adviser firm employees will now need to report the personal trades they make in certain types of virtual currency tokens.
On July 25, 2017, the SEC issued a series of releases in which the agency articulated, for the first time, its view that virtual currency tokens offered or sold as part of an Initial Coin Offering (“ICO”) may constitute “securities” and that certain types of ICOs are therefore subject to the federal securities laws.
The SEC’s new position on virtual currency has significant potential legal and compliance implications for various types of securities industry participants, including SEC-registered investment advisers. How exactly this regulatory development affects a given registered adviser will depend on what type of investment strategy that adviser pursues on behalf of its clients. Certainly, the SEC commentary on virtual currency tokens and ICOs will have a more significant impact on advisers that trade in virtual currency tokens as part of their investment strategy than on advisers that do not.
The SEC commentary, however, does have at least one compliance implication that affects all registered investment advisers. The implication relates to Rule 204A-1 under the Investment Advisers Act (“Advisers Act”). In particular, pursuant to Rule 204A-1, which generally requires advisers to adopt a code of ethics, if an “access person” (defined below) of a registered adviser engages in personal trading of virtual currency tokens that constitute “reportable securities” (defined below), the access person must (1) report such trades on a quarterly basis and (2) report his or her holding of such tokens upon becoming an “access person” and on an annual basis thereafter.
This article focuses on how the SEC’s new position on virtual currency tokens impacts Rule 204A-1 compliance obligations, as this topic is relevant to the entire registered investment adviser community.
Background on Initial Coin Offerings
Since the advent of distributed ledger or blockchain technology in the mid-2000s, developers and businesses have started using ICOs, or sales of virtual currency tokens, to raise capital. ICOs have grown in popularity in recent years, in part because, until recently, they have been unregulated and therefore a less expensive alternative to highly regulated initial public offerings.
Investors may generally purchase the tokens offered in ICOs with fiat currency like U.S. dollars or with other virtual currencies. At the start of the ICO process, the promoters of the ICO typically communicate to potential investors the rights or benefits attached to the tokens to be offered. These rights or benefits vary for each ICO but often include the right to use or participate in a digital platform, software program, or other project the promoters plan to develop using the capital they raise. The rights and benefits provided to token-holders may also include a share of the returns generated by such projects. Typically, the tokens purchased in an ICO may be resold to third parties in a secondary market via a virtual currency exchange or some other platform.
An ICO conducted by a now-defunct organization called The DAO, which was the subject of much of the SEC’s recent commentary on virtual currency, provides an illustrative example of what an ICO could look like. The DAO was created by Slock.it, a German for-profit entity that sought to sell “DAO Tokens” to raise capital for funding various business projects. The DAO’s operations were managed by Slock.it, Slock.it’s founders, and certain individual “curators” selected by Slock.it and its founders.
Investors could purchase DAO Tokens by contributing a form of virtual currency called Ether to The DAO. In exchange, investors received certain limited ownership and voting rights attached to the DAO Tokens. Specifically, according to the ICO promotional materials distributed by Slock.it, DAO Token holders would receive a share of any profits The DAO earned from funding these business projects. In addition, token-holders could vote on “curator-vetted” contract proposals, including those made to The DAO to fund specific business projects and to distribute anticipated earnings from the projects it funded.
The SEC’s Commentary on ICOs
On July 25, the SEC issued three publications related to ICOs: (1) “Report of Investigation Pursuant to Section 21(a) of the Securities Exchange Act of 1934” (the “Report”), which described the agency’s investigation of The DAO and its sale of tokens to raise capital; (2) a press release summarizing the observations the SEC made in the Report; and (3) an Investor Bulletininforming investors about virtual currency, ICOs, and some key points to consider before participating in an ICO.
In the Report, the SEC analyzed whether the tokens sold as part of The DAO ICO fit within the definition of “securities” under the Securities Act of 1933 (“Securities Act”) and the Securities Exchange Act of 1934 (“Exchange Act”). The SEC’s analysis focused on whether the DAO Tokens would each be considered an “investment contract,” an instrument the two statutes expressly include in their respective definitions of “securities.” In determining whether the tokens were “investment contracts,” the SEC applied the four-prong test articulated in the Supreme Court decision in SEC v. W. J. Howey Co. The Howey test defines an “investment contract” as (1) an investment of money (2) in a common enterprise (3) with a reasonable expectation of profits (4) to be derived from the entrepreneurial or managerial efforts of others.
Applying the Howey test to DAO Tokens, the SEC explained that the first two prongs were satisfied because investors invested money in The DAO, a common enterprise. The SEC reasoned that the third prong was also satisfied because the ICO promotional materials promised investors a share of profits earned on projects to be funded by The DAO. The fourth and final prong was given the most extensive analysis in the Report. Ultimately, the SEC concluded that future profits were “to be derived from the entrepreneurial or managerial efforts of others,” pointing out that Slock.it and its founders monitored The DAO’s operations and selected the “curators” who vetted proposals before they were submitted to DAO Token holders for a vote.
On this basis, the SEC determined that The DAO ICO was an offering of securities under the Securities Act. Therefore, The DAO needed to register with the SEC pursuant to Section 5 of that act (like an IPO) unless it could rely on an exemption from registration such as the private placement exemption provided under Section 4(2) of the act. Finding that no such exemption was available to The DAO, the SEC concluded that the organization conducted an unregistered offering of securities in violation of Section 5.
Responding to this SEC commentary, law firms have emphasized that whether an ICO involves an offering of securities depends on the individual ICO facts and circumstances. As the Report’s Howey test analysis makes clear, tokens offered in ICOs only constitute securities if profits are “to be derived from the entrepreneurial or managerial efforts of others,” the fourth prong of the test. As such, the precise rights and benefits vested in ICO token-holders are critical to the analysis. If the token-holders exercise a sufficient degree of managerial control over the profits they earn, then the fourth prong of the Howey test would ostensibly not be satisfied and the tokens would not be deemed “securities.”
Applicability of the SEC’s Commentary on Virtual Currency to the Advisers Act
The investment adviser community is primarily regulated by the Advisers Act.While the SEC Report focuses on the application of the Securities Act and the Exchange Act, it does reference the Advisers Act in a footnote. In this footnote, the SEC clarified that the Report does not analyze whether anyone associated with The DAO fits within the definition of an “investment adviser” under the Advisers Act and cautioned virtual organizations to consider their obligations under the act.
Like the Securities Act and Exchange Act, the Advisers Act definition of the term “securities” includes an “investment contract.” This definition can be found in Section 202(a)(18). Although the SEC has not issued any formal guidance on whether the Howey test should be applied with respect to the Advisers Act definition of “securities,” it is highly likely that an instrument deemed an “investment contract” under the Securities Act and Exchange Act would also be deemed an “investment contract” under the Advisers Act. As such, it is also highly likely that, based on the SEC’s recent commentary, certain virtual currency tokens would be considered “securities” for purposes of Advisers Act regulations, including Rule 204A-1, the subject of this article.
An Overview of Rule 204A-1 under the Advisers Act
Rule 204A-1 requires registered investment advisers to maintain and enforce a code of ethics that includes, among other things, provisions requiring the adviser’s “access persons” to periodically report, and the adviser to review, their personal securities transactions and holdings. An “access person” is defined as any of the adviser’s supervised persons who (i) has access to nonpublic information regarding any clients’ purchase or sale of securities, (ii) is involved in making securities recommendations to clients or has access to such recommendations that are nonpublic, or (iii) has access to nonpublic information about the portfolio holdings of any reportable fund (i.e., a registered investment company managed by the adviser).
Pursuant to Rule 204A-1, access persons are generally required to submit three types of reports to the adviser:
- Initial holdings reports must be submitted upon becoming an access person. Such reports must detail (i) all accounts in which securities are held for the access person’s direct or indirect benefit and (ii) the name and quantity of each “reportable security” in which the access person has direct or indirect beneficial ownership. Access persons are presumed to have beneficial ownership over securities held by their “immediate family members” who reside in the same household, although such a presumption may be rebutted.
- Annual holdings reports must be submitted at least once during each subsequent year. These reports must contain the same information as initial holdings reports.
- Quarterly transaction reports must be submitted after the end of each calendar quarter. Such reports must detail certain information with respect to each transaction an access person made in reportable securities during the given quarter (e.g., security name, transaction date, price, etc.).
It is worth highlighting that transaction reports are only required for transactions in “reportable securities.” A “reportable security” is any security as defined in Section 202(a)(18) of the Advisers Act except for the following five categories of non-reportable securities:
- Direct obligations of the U.S. government
- Bankers’ acceptances, bank certificates of deposit, commercial paper and high-quality, short-term debt instruments, including repurchase agreements
- Shares issued by money market funds
- Shares issued by open-end investment companies registered under the Investment Company Act of 1940 other than certain “reportable funds”
- Shares issued by unit investment trusts invested exclusively in one or more open-end funds, none of which are “reportable funds”
In addition to its reporting requirements, Rule 204A-1 imposes a pre-approval requirement for access person personal securities trading. Access persons must obtain approval prior to acquiring beneficial ownership in any security in an initial public offering registered with the SEC under the Securities Act or in any limited offering exempt from Securities Act registration pursuant to Section 4(2) or Section 4(5) of the same act. Section 4(2) sets forth the commonly used private placement exemption, and Section 4(5) sets forth an exemption for private offerings of a limited size made solely to accredited investors. As explained above, access persons are presumed to have beneficial ownership over securities held by immediate family members who reside in the same household.
Virtual Currency Tokens and Compliance with Rule 204A-1
Rule 204A-1 personal trading and holdings reporting requirements only apply to trades and holdings of “securities” as defined by the Advisers Act. In determining whether personal trades in virtual currency tokens must be reported pursuant to Rule 204A-1, the threshold question is whether the tokens fall within the Advisers Act definition of “securities.” The SEC commentary states that, applying the Howeytest, tokens offered in an ICO are “securities” for purposes of the Securities Act and Exchange Act only if investors reasonably expect profits to be derived from the entrepreneurial or managerial efforts of others. As explained above, it is highly likely that any tokens deemed “investment contracts” under the Securities Act and Exchange Act based on the SEC’s Report would also be deemed “investment contracts” (and therefore “securities”) under the Advisers Act.
To be clear, virtual currency tokens that function like units of fiat currency and that do not involve investments in common enterprises like The DAO are not “securities.” Most virtual currency tokens in circulation today therefore fall outside the orbit of securities regulations. That said, for tokens offered in an ICO structured such that the tokens may be deemed “investment contracts” under the Howeytest, advisers should consider taking a conservative approach and treating the tokens as “securities” for purposes of Rule 204A-1.
If certain tokens are deemed “securities” for purposes of the Advisers Act, the next question is whether they are “reportable securities.” A security is “reportable” unless it fits one of the five categories of non-reportable securities listed above: U.S. government securities, bank products and short-term debt instruments, money market fund shares, registered investment company shares, and unit investment trust shares. Virtual currency tokens do not fit within these categories.
Consequently, tokens deemed “securities” under the Advisers Act would presumably be “reportable securities” subject to Rule 204A-1 reporting requirements. Access persons of advisers who buy or sell such tokens must (i) initially report their holdings of these tokens upon becoming access persons, (ii) annually report their holdings of these tokens, and (iii) report on a quarterly basis any trades made in these tokens. Such reports must also be submitted with respect to any trading or holding of such tokens by immediate family members who reside in the same household as the access persons unless the presumption of beneficial ownership over family member holdings can be rebutted.
The holding reports should detail, among other things, the name and quantity of each token held. The transaction reports should detail for each token traded, the token name, the trade date, the type of trade (e.g., buy or sell), the quantity traded, and the trading price (in either fiat or virtual currency terms, as applicable). These reports, however, would not be required with respect to any token trades made in an account over which the access person has no direct or indirect influence or control.
An access person’s purchase of tokens deemed “securities” under the Advisers Act would also be subject to the Rule 204A-1 pre-approval requirement if the purchase were part of an IPO registered with the SEC under the Securities Act or a “limited offering.” Accordingly, if ICO promoters opt to register the securities with the SEC, access persons would need to obtain compliance approval before purchasing the tokens. Pre-approval would also be required for any “limited offering,” which is defined as an offering exempt from registration pursuant to the Section 4(2) private placement exemption or the Section 4(5) exemption for private offerings of a limited size made solely to accredited investors. However, as of this writing, it remains unclear whether ICO promoters would be willing and able to absorb the costs associated with SEC registration or to accept the marketing constraints associated with private offerings.
It is worth noting that advisers’ codes of ethics often impose personal trading rules more demanding and restrictive than the Rule 204A-1 requirements. For example, a code of ethics may require pre-approval for reportable securities trades that do not involve IPOs or limited offerings. A code may also require personal trade reports from all employees, even those who may not be “access persons.” For such advisers, the specific circumstances under which employees must report their personal trading and holding of virtual currency tokens will be set forth in their codes of ethics.
In light of the SEC’s new position on virtual currency tokens, investment advisers should ensure that access persons report any personal trades in tokens that would likely be deemed “securities.” Advisers might also consider amending their personal trading policies and procedures to clarify that (i) trades in virtual currency tokens offered or previously offered as part of an ICO may need to be reported and (ii) access persons who purchase these types of tokens should consult with compliance staff about whether the tokens are “securities” given their particular attached rights and benefits. The policies and procedures should detail the applicable reporting obligations for tokens deemed “securities.” Alternatively, advisers may conclude it is easier to assume that all tokens offered or previously offered as part of an ICO are “securities” and therefore “reportable securities” to be included in access persons’ code-of-ethics reporting.
Advisers should also assess whether the current personal trade pre-approval requirements in their codes of ethics apply to trades in tokens deemed “securities.” Should an adviser’s code of ethics require pre-approval for such trades, the adviser should either ensure that its access persons obtain pre-approval for any personal trades in such tokens or amend its code of ethics to exempt these tokens from trade pre-approval requirements. Regarding the latter approach, however, we note that it may be prudent for advisers that regularly trade in certain types of virtual currency tokens as part of their investment strategy to require access persons to obtain pre-approval for personal trades in these tokens.
See, e.g., Pepper Hamilton LLP, “Blockchain and Initial Coin Offerings: SEC Provides First U.S. Securities Guidance,” July 27, 2017 (“The SEC did not outlaw ICOs by any stretch of the imagination, but it did indicate that, depending on the facts and circumstances, an ICO may indeed involve an offering of securities.”); K&L Gates, “DAO and the Art of Securities Regulation: SEC Clarifies that Digital Tokens May Be ‘Securities,’” August 1, 2017 (“The SEC will look closely at the facts and circumstances of a token offering under applicable statutes and precedent to determine whether a token constitutes a ‘security,’ starting with the Howey analysis noted above.”); or Latham & Watkins, “SEC: Certain Initial Coin Offerings Are Securities Offerings,” July 27, 2017(“Market participants who are considering using an ICO to raise funds should carefully analyze the particular facts and circumstances under the existing regulatory framework to determine whether the tokens may be securities. In particular, they should take into account various rights attributed to the tokens and the economic realities underlying the transaction structure.”)
See Mitchell L. Berg et al., “Considerations in Complying with the Investment Advisers Act,” New York Law Journal 252, No. 5, July 9, 2014, which discusses what types of real-estate investments may be considered “securities” under the Advisers Act; see also Cott Law Group, “Starting a Cryptocurrency Fund: Valuation Considerations,” August 22, 2017 (“We believe it is best practice for fund managers who intend to invest in ICOs to preemptively follow the applicable registration requirements imposed by the Investment Advisers Act of 1940 or applicable state securities regulator.”)
Immediate family members include children, stepchildren, grandchildren, parents, stepparents, grandparents, spouses, siblings, mothers-in-law, fathers-in-law, sons-in-law, daughters-in-law, brothers-in-law, or sisters-in-law and any such adoptive relationships.
Advisers may opt to receive duplicate trade confirmations and account statements in lieu of transaction reports provided that such reports contain all the information required by Rule 204A-1 and are received by the adviser within the required time frame.
A “reportable fund” generally means any registered investment company that is advised by the adviser itself or by certain of its affiliates.
Rule 204A-1 provides an exemption to reporting requirements for securities held in an account over which an access person has no direct or indirect influence or control. If an access person maintains a personal securities account with a third-party investment manager, his or her quarterly transaction reports do not need to detail reportable security transactions made in this account, provided the access person has no influence or control over the account.