In order to provide an overview for busy in-house counsel and compliance professionals, we summarize below some of the most important SEC enforcement developments from the past month, with links to primary resources. This month we examine:

• A settled action against a fund administrator for alleged lack of oversight of investment advisers;
• The SEC’s first-ever Amended Marketing Rule action against an investment adviser;
• A new SEC rule regulating private fund advisers;
• A settled action involving non-fungible tokens (NFTs); and
• A court of appeals’ decision vacating the SEC’s denial of an investment application.

1. SEC Charges Fund Administrator for Missing Red Flags and “Causing” Underlying Securities Violations

On August 7, 2023, the SEC settled charges with Theorem Fund Services, LLC (TFS), an independent fund administrator, for “causing” violations by previously charged investment advisers EIA All Weather Alpha Fund Partners and its owner Andrew M. Middlebrooks. In May 2022, the SEC charged EIA and Middlebrooks, alleging they repeatedly made false and misleading statements about a private fund’s performance and assets that were provided to investors.

The settlement with TFS suggests that the SEC is continuing to focus on gatekeepers and other secondary actors even after charging primary actors’ direct violations. Here, TFS was accused of causing the advisers’ violations by performing acts as directed by the advisers without evaluating whether they were appropriate and by accounting for fund losses in a manner directed by the advisers, despite red flags. In particular, the SEC found that TFS “had minimal policies or procedures regarding onboarding new clients” beyond those found in the administrative agreement with the fund and had “minimal policies or procedures regarding accounting practices to follow when calculating a fund’s NAV” leading to the problems addressed in the settlement. For example, while the administrative agreement required EIA to provide TFS with access to monthly account statements, EIA never did so. Similarly, the administration agreement required EIA to appoint an independent auditor, but TFS did not timely confirm that EIA had done so, and when it eventually did try to confirm an auditor had been hired, TFS learned the advisers had never done so. The SEC further found that TFS calculated an inflated NAV for the fund and prepared investor statements and fact sheets that did not accurately reflect the fund’s performance, contributing to the misrepresentation of the fund’s financial health.

The SEC found that TFS caused EIA’s and Middlebrooks’ violations of Sections 17(a)(2) and 17(a)(3) of the Securities Act of 1933 (the “Securities Act”) and Rule 206(4)-8(a)(1) of the Investment Advisers Act of 1940 (the “Advisers Act”). TFS agreed to a cease-and-desist order without admitting or denying liability. TFS agreed to pay a civil penalty of $100,000, disgorgement of $18,000, and prejudgment interest of $4,271.

#FollowTheRedFlags #StrengthenYourAccountingPolicies #OversightIsKey

2. SEC Brings First Charges for Violation of its Amended Marketing Rule

On August 21, 2023, the SEC settled with Titan Global Capital Management USA LLC (“Titan”), a fintech investment adviser, for more than $1 million. This settlement resolves claims that Titan advertised misleading hypothetical performance projections, making it the first adviser to be sanctioned under the SEC’s amended marketing rule which was updated in December 2020. The amended rule aims to regulate registered investment advisers’ marketing practices in response to the increasing use of online platforms by investors.

According to the SEC order, Titan did not develop written policies and procedures or adapt its business to comply with the amended marketing rule. Furthermore, Titan allegedly promoted trading strategies through advertisements on its trading application that included performance projections that omitted critical information, such as the assumption that a strategy’s performance over a few weeks would continue for a year. Additionally, the SEC alleged that some models, including one for cryptocurrency trading, projected results as high as 2,700%, and did not disclose that the high return was based on a purely hypothetical account.

Titan was found to have violated the Marketing Rule by advertising hypothetical performance without implementing policies and procedures to ensure relevance to the intended audience’s financial situation and objectives, failing to provide certain underlying information for the hypothetical advertised performance, and providing misleading advertisements on its website about the hypothetical performance. The SEC claimed that Titan also included disclaimer language often called a “hedge clause” in client agreements that allegedly misled their clients by purporting to relieve advisers of liability for conduct that is non-waivable under state or federal law and failed to obtain client signatures before transferring client funds.

The SEC determined that Titan violated several sections of the Advisers Act, including Section 206(2) of the Advisers Act, which prohibits fraudulent or deceitful practices with clients; Section 206(4) of the Advisers Act and Rules 206(4)-1 and 206(4)-7, which concern the dissemination of misleading advertisements and the failure to adopt policies and procedures to prevent violations. The order requires Titan to pay disgorgement of $192,454, prejudgment interest of $7,598, and a civil monetary penalty of $850,000. Notably, the order acknowledges that the civil penalty amount is not in excess of $850,000 due to Titan’s cooperation—including hiring a new Chief Compliance Officer and Chief Legal Counsel, and conducting internal audits that led to the self-reporting of inappropriately applied client signatures on transaction documents—but warns that additional penalties may be imposed if it is found that Titan knowingly provided false or misleading information to the Commission in the future.

For further details and recommendations on compliance with the Marketing Rule, read our Client Alert.

#EyesOnTheMarketing #TruthInAdviserPerformance #MarketingRuleCompliance

3. SEC Adopts New Rules for Private Fund Advisers

On August 23, 2023, the SEC introduced new rules and amendments to the Advisers Act, aimed at bolstering the oversight and transparency of private fund advisers. Under these rules, registered private fund advisers must provide quarterly statements to investors detailing private fund performance, fees, and expenses. They are also required to obtain an annual audit for each private fund and secure a fairness opinion or valuation opinion in cases of adviser-led secondary transactions, obtain fairness or valuation opinions for GP-led secondaries, and compose a written report of the adviser’s annual compliance program review.

Furthermore, all private fund advisers must prohibit certain activities and practices detrimental to the public interest and investor protection unless they disclose these actions to investors and, in some cases, obtain investor consent. Under the new rules, private fund advisers must refrain from offering certain forms of preferential treatment that negatively impact other investors unless disclosed to current and potential investors.

These regulations are particularly significant as private funds and their advisers have become increasingly influential in financial markets, with a steady growth in assets under management over the past decade. The rules will become effective upon publication in the Federal Register and are subject to change, with compliance deadlines ranging from 60 days to 18 months depending on the provision.

The rules were passed by a 3-2 vote. The SEC’s majority argued that these rules are essential to enhance transparency and mitigate conflicts in the private funds industry, which manages an estimated $26.6 trillion in assets. Some opponents, however—including private equity, venture capital, and hedge funds—have contended that the SEC is overstepping its authority and interfering with private negotiations. On September 1, 2023, industry groups National Association of Private Fund Managers and Managed Funds Associations, among others, filed a petition for review challenging the validity of the rules in the Fifth Circuit Court of Appeals. These groups argue that the new rules are arbitrary and capricious and “exceed the Commission’s statutory authority.”

#PrivateFundAdviserTransparency #EqualTreatmentforInvestors

4. SEC Determines Impact Theory NFTs Are Unregistered Securities

On August 28, 2023, the SEC settled with media and entertainment company Impact Theory for allegedly offering and selling crypto assets known as Founder’s Keys (“KeyNFTs”) in the form of non-fungible tokens (NFTs). Impact Theory allegedly raised nearly $30 million worth of ETH coins through its KeyNFT sales. This is the first enforcement action premised on an allegation that NFTs are securities.

The SEC found that the KeyNFTs were sold as investment contracts, and therefore were securities under the Supreme Court’s Howey test because purchasers “had a reasonable expectation of obtaining a future profit based on Impact Theory’s managerial and entrepreneurial efforts.” In particular, the SEC alleged that Impact Theory told investors in public statements and at company events that the Founder’s Key’s value would increase if the company’s project was successful. For example, Impact Theory allegedly told investors that the company’s plans “will leave the upside to be largely captured by you guys [investors], and the tokens were “a tremendous way for our community to capture tremendous value from the things that we’re building.”

Impact Theory was found to have violated Sections 5(a) and 5(c) of the Securities Act by not having a registration statement filed or an exemption from registration for the sale of these securities. As part of the settlement, Impact Theory is required to cease and desist from further violations, destroy all KeyNFTs, and pay disgorgement of $5,120,718.27, prejudgment interest of $483,195.90, and a civil penalty of $500,000. The SEC noted Impact Theory’s repurchase of 2,936 KeyNFTs as a remedial effort was taken into consideration when determining to accept Impact Theory’s offer of settlement, as those repurchases returned approximately $7.7 million worth of ETH to investors.

#NFTsAsSecurities #CrytoRegulation #NFTsUnderHowey

5. D.C. Circuit Court Vacates the SEC’s Denial of Grayscale Investments’ Application for a Bitcoin ETF

On August 29, 2023, the D.C. Circuit issued a ruling that the SEC must reconsider Grayscale Investments’ application to list bitcoin exchange-traded products (ETPs). The court vacated the SEC’s previous rejection of Grayscale’s bitcoin ETPs, finding that the regulator failed to adequately explain why it approved bitcoin futures ETPs, which track agreements to exchange bitcoin at a specified price, but not Grayscale’s spot bitcoin ETP that proposed using similar market safeguards. Despite these strong similarities, the Commission rejected Grayscale’s proposed bitcoin ETP while approving two bitcoin futures ETPs, citing the significant market test as the distinguishing factor. The Commission requires bitcoin-based ETPs to have surveillance sharing agreements with related, regulated, and significant-size markets to address fraud and manipulation concerns.

Grayscale challenged the SEC’s decision as arbitrary and capricious, arguing that if the bitcoin futures market is resistant to manipulation, the spot market must also be, as futures prices are based on spot activity and rely on bitcoin’s underlying price. The D.C. Circuit agreed, noting a 99.9% correlation between bitcoin’s spot market and futures contract prices. “It is a fundamental principle of administrative law that agencies must treat like cases alike,” the Court explained.

The decision does not guarantee approval of a spot bitcoin ETP but requires the SEC to revisit the application, potentially restarting a lengthy process. Even so, the decision is being hailed by many in the cryptocurrency industry who have previously expressed frustration with how the SEC has handled the application process for crypto market participants looking to work within existing rules to forge a path forward collaboratively with the Commission.

#ETPRegistration #JudicialOversightforSEC #CryptoCompliance

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