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News September 17, 2018 Issue

Cryptocurrency: SEC Takes Action Against Hedge Fund Manager

It was only a matter of time before it happened. The SEC on September 11 took what it called its “first-ever enforcement action” against a hedge fund manager marketing digital assets. The firm had raised more than $3.6 million for such investments over a four-month period – but the agency charged that it did so using misrepresentations and registration failures.

California-based Crypto Asset Management, a firm that the SEC said “has never been registered with the Commission in any capacity,” had been falsely marketing itself as the “first regulated crypto asset fund in the United States,” the agency said. Both the firm and its founder and sole principal, Timothy Enneking, on September 11 settled with the SEC. Both parties were censured and agreed to pay a $200,000 civil money penalty.

“Hedge funds seeking to ride the digital asset wave continue to proliferate,” said SEC Division of Enforcement Asset Management Unit co-chief C. Dabney O’Riordan. “Investment advisers must be sure that the funds they offer adhere to the applicable registration obligations and must accurately represent their funds’ regulatory status to members.”

In addition to misrepresenting its registration status, the other charge made by the agency against Crypto Asset Management was that it failed to register as an investment company with the Commission, something that the SEC says it was required to do under the Investment Company Act because its digital assets that were investment securities exceeded 40 percent of its fund’s total assets.

“The settlement is something of a cautionary tale for managers and others getting involved in cryptocurrencies,” said Kirkpatrick Townsend partner Paul Foley. “The SEC is not likely to be so forgiving in the future.”

The company’s statement that it was the first regulated crypto asset fund in the country “was a pretty bold, significant statement, and couldn’t be further from the truth,” he said. “Overall, it’s a pretty light penalty given the nature of the violation. A lot of credit was probably given to the company’s remedial actions and its cooperation with the Commission.”

“Interestingly, the settlement order doesn’t actually talk about what types of crypto assets were held by the hedge fund,” said Mayer Brown partner Adam Kanter. “The order asserts, without discussion, that at least 40 percent of the assets held by the fund were investment securities. While it isn’t uncommon for settlement orders to not delve into some of the facts and interpretive issues underpinning the violation, this definitely leaves a question of which particular assets the SEC was viewing as ‘securities’ and which, if any, it was not.”

The fund and the investments

Crypto Asset Management and Enneking formed the fund in March 2017 “for the purpose of investing in digital assets,” according to the settlement order. Enneking had experience with cryptocurrencies, having previously operated private funds in foreign countries that invested in digital assets, the agency said. The fund in question here, however, was his first U.S.-based fund and, the SEC acknowledged, Crypto Asset Management and Enneking “engaged counsel to provide general and privileged advice to [the firm] on regulatory compliance matters in connection with launching and operating [the fund].”

“From August 1, 2017 through December 1, 2017, respondents raised over $3.6 million from 44 investors, primarily individuals, residing in at least 15 states,” the SEC said.

In doing so, according to the administrative order, Crypto Asset Management and Enneking “controlled and directed” the investments of the fund’s assets. Crypto Asset Management “earned incentive and management fees from [the fund] pursuant to the terms of its management agreement with [the fund], and Enneking received distributions from Crypto Asset Management pursuant to Crypto Asset Management’s limited partnership agreement.”

Given that the order states that the two respondents did not have pre-existing relationships with the investors, how did they raise the capital from them? According to the SEC, they “engaged in a general solicitation of public interest in the offering through Crypto Asset Management’s website, social media accounts, and traditional media outlet interviews.”

Crypto Asset Management “did not file or cause to be filed a registration statement with the Commission, and no exemption from registration was available during the relevant period,” the agency said.

The 40 percent question

Further, the SEC charged, Crypto Asset Management “caused [its fund] not to comply with the Investment Company Act.” Under Section 3(a)(1)(C) of the Act, an investment company is defined as an issuer that “is engaged in or proposes to engage in the business of investing, reinvesting, owning, holding or trading in securities, and owns or proposes to acquire investment securities having a value exceeding 40 per centum of the value of such issuer’s total assets (exclusive of government securities and cash items) on an unconsolidated basis.”

The fund met this definition of an investment company, but “did not register with the Commission as an investment company, meet any statutory exemptions or exclusions from the definition of an investment company, or seek an order from the Commission declaring that it was primarily engaged in a business other than that of investing, reinvesting, owning, holding or trading in securities, or exempting it from complying with any provisions of the Investment Company Act or the rules thereunder,” the SEC said. “Thus, during the relevant period, [the fund] should have registered with the Commission as an investment company.”

Marketing
The SEC also faulted the company for failing to take reasonable steps to ensure the accuracy of certain statements before disseminating them to actual and potential investors. Specifically, according to the settlement order, Crypto Asset Management and Enneking “negligently misrepresented to actual and prospective investors in certain marketing materials that [the fund] was the ‘first regulated crypto asset fund in the United States’ and had filed a registration statement with the Commission.”

After the SEC contacted Crypto Asset Management and undertook a review of its website, marketing materials and offering procedures, the agency said, “respondents immediately halted the offering.”

Beyond that, Crypto Asset Management and Enneking took some other steps following the SEC contact, according to the settlement order. Specifically, they:

  • Verified the accredited status of investors who invested in the fund,
  • Made a recission offering pursuant to a valid exemption from registration to each of the investors,
  • In connection with the recission offering, disclosed their previous misstatements to investors and prospective investors, and
  • In January 2018, began offering securities pursuant to the Regulation D Rule 506(c) exemption from registration.

Violations

Under the settlement, Crypto Asset Management was found to have violated Section 5(a) and (c) of the Securities Act, both of which prohibits the sale of securities, as well as the offer to sell them, without a registration being in effect. The company was also charged with causing the fund’s violation of Section 7(a) of the Investment Company Act, which makes it illegal for a non-registered investment company to engage in interstate commerce.

Both Crypto Asset Management and Enneking were found to have willfully violated Section 17(a)(2) of the Securities Act, which forbids the selling of securities through the use of an untrue statement of material fact or the omission of a material fact. Finally, both respondents were found to have violated Section 206(4) of the Advisers Act and its Rule 206(4)-8, which prohibits an adviser from making any untrue statement of material fact or the omission of one. An attorney representing Crypto Asset Management and Enneking, when reached, chose not comment on the settlement.