SEC Registration Complicates Crypto Fundraising and Advisory Role

General sentiment that fundraising will improve, a bull market, and other encouraging developments with the approval of Bitcoin exchange-traded funds fuel fundraising optimism among digital asset fund managers. Here’s what prospective managers may be considering in their fundraising process.

SEC Registration

It is likely that at some point, a digital asset fund manager will need to register with the Securities and Exchange Commission as an investment adviser—a person or entity that engages in the business of providing advice with respect to securities for compensation.

If you start a business that sponsors funds investing in digital assets—some of which may be securities, according to the SEC—you’re likely an investment adviser. However, many first-time digital asset fund managers may rely on a few exemptions from registration.

Exemptions

The first exemption is the private fund adviser exemption, which provides that investment advisers managing only private funds with aggregate assets under management under $150 million are exempt from registration.

Second is the venture capital fund adviser exemption, which provides that investment advisers managing only venture capital funds are exempt, regardless of the amount of assets under management.

Liquid digital asset managers that start small may be able to initially rely on the private fund adviser exemption. If you pursue a less liquid strategy and make investments in startup companies, you may be able to benefit from the venture capital fund adviser exemption.

Compliance Considerations

Even unregistered investment advisers are subject to anti-fraud rules under the Investment Advisers Act and may be subject to SEC inquiries. We recommend some compliance planning, particularly policies and procedures surrounding books and records requirements, and managing conflicts of interest.

The SEC also passed new rules regulating private fund advisers. When effective, they will affect all investment advisers, registered and unregistered.

Several powerful industry groups filed a lawsuit challenging SEC authority to pass the rules, and it’s pending in the US Court of Appeals for the Fifth Circuit. Fund managers should prepare and consider implications of the rule with regulatory counsel in case it’s upheld.

Digital Asset Custody

Unregistered advisers aren’t subject to the Custody Rule under the Advisers Act, which requires that for private funds, all funds and securities be custodied with a qualified custodian and the funds be subject to an annual audit.

If required to register, you will need to think about navigating the Custody Rule, which has been problematic for digital asset managers. Qualified custodians don’t have service offerings to custody some digital assets.

In our experience, some auditors have decided not to service digital assets in light of reputational risks that arose for auditors in 2022 and 2023, resulting in audits in the space becoming generally more expensive.

An SEC rule proposal is currently outstanding for significant amendments to the Custody Rule, which was the subject of substantial comments and concern from the digital asset industry. If this rule is adopted, digital asset funds managers will have to stay aware.

Service Providers

You’ll need to engage counsel, a fund administrator, and possibly a fund auditor as service providers. Some funds engage a placement agent to help sell fund interests. The cost of forming a fund will vary based upon the investor base and structure.

These service providers range in pricing, and costs are typically borne by the fund as organizational expenses or ongoing fund expenses. The sponsor may be out of pocket for some of those expenses until the fund launches, at which point the sponsor can be reimbursed from the fund.

For liquid funds, organizational expenses are typically amortized over a five-year period, which means that all investors in the fund will bear a portion of that expense in their monthly net asset value. An investor that makes an investment in the third year of the fund’s life will still bear a portion of the fund’s organizational expenses despite not investing at the initial launch.

It’s common to have an organizational expense cap in the fund documents with illiquid strategies. Upon the fund’s first capital call, the sponsor often will call for organizational expenses to pay those expenses or reimburse the sponsor. Often the sponsor will also call amounts required for the first fund investments and for payment of management fees.

Launch Timing

Timing will vary based on the complication of the structure and the composition of the investor base. For example, if you’re raising offshore money, that may require the creation of a parallel offshore vehicle and the engagement of offshore counsel.

The more institutionalized the potential investors, the higher likelihood they will hire their own counsel, review the fund documentation carefully, and negotiate for certain rights in the fund documents, which can increase timing.

A simple fund structure with only US individual investors may take as little as two months. Liquid funds, where the sponsor can take investments perpetually, will often be quicker to launch than an illiquid fund, where the sponsor will want a critical mass in the first closing but can continue raising commitments for a year or more.

This article does not necessarily reflect the opinion of Bloomberg Industry Group, Inc., the publisher of Bloomberg Law and Bloomberg Tax, or its owners.

Author Information

Brian Forman is partner and chair of the investment funds and advisers practice at Morrison Cohen.

Tracy Sigal is senior counsel in the investment funds and advisers practice at Morrison Cohen.

Write for Us: Author Guidelines