Crypto Hedge Fund- Common Formation Mistakes

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Regulatory minefield

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Operating a crypto hedge fund heightens the legal exposure of involved entities and individual partners and managers, even as compared to already sky-high exposure in a traditional hedge fund, due to the existing, traditional (over)regulation of financial institutions, glaring regulatory uncertainty as relates to crypto, and some legacy of omitting lingering compliance issues by predecessor crypto hedge funds of the last decade.

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The existing regulatory landscape is akin a complex minefield. No one has and is going to make an exception for crypto, and all the heavy, burdensome and expensive domestic and global corporate compliance regulation of financial institutions applies to crypto hedge funds as of now. Think SEC, CFTC, FinCen, FinRA, OFAC, FATFA, BSA, soon, and inevitably, Basel III, and state regulations of investment advisors, with its notorious thought leaders- The New York State Department of Financial Services (NYSDFS) and The District Court for the Southern District of New York (SDNY).

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Early crypto hedge funds could be divided into two parts: those just holding “blue chips”- Bitcoin and Ethereum, and those actively using decentralized platforms and self-custodial options, ranging from discretionary long to high frequency trading, in reliance on the obvious lag in regulation of the crypto space. Some of them had an opportunity to grab their share of plunder and close before the regulators’ reach.

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When former Goldman Sachs' partner Gary Gensler, formerly also chairman of the U.S. Commodity Futures Trading Commission, the under secretary of the Treasury, became the chair of SEC, the crypto world gasped and began scratching their heads: Gensler taught blockchain technology, digital currencies, financial technology, etc. in MIT, so the reliance on lag in expertise or care about crypto had disappeared overnight. Those curious about Professor Gensler’s views and classifications of crypto assets, can watch his MIT course here- it is dated 2018, but fundamentals and principles are there, and one may find it thrilling to see how the industry was looked upon back then.

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Common hedge fund pre-launch mistakes

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Many prospective fund managers begin the fund formation with preparing decks, presentations, elevator pitches, executive summaries, white papers and even drafting contracts or formation documents, failing to recognise the stretch of the US regulatory reach. They often include some dated, copypasted disclaimers that fall short of regulatory compliance required for communicating with prospective investors, violate rigid federal and state regulations, and expose the fund and its directors to liability. It is important to know that even the pre-launch marketing material is subject to regulatory review, including for funds that are exempt from registration requirements.

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The Investment Advisers Act imposes liability on managers of investment funds for omissions or misstatements, including the case where the error was not willful, the statement was not made in connection with a sale to an investor, or the statements were made to investors who never actually invested. Even before the harsh penalties, the first blow could come in the form of an investment contract rescission, meaning repayment of the investment made, with interest, and attorney fees and costs. 

Personal liability

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Section 10(b) of the Securities Exchange Act of 1934 (Exchange Act) imposes liability on individual directors’ and officers,’ where a payment can be ordered from personal assets. If the SEC can prove that failure to properly disclose material issues or making false or misleading statements were willful, the fines can be imposed up to five million dollars, coupled with or substitutes by imprisonment of up to twenty years.

In addition, each state in which a security was sold may impose its own penalties against the directors and officers of the issuing company. See here the major laws and regulations that a crypto hedge fund must comply with, and the major regulatory authorities that enforce such continuous compliance.

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