By Eric Jacobs/ Essential Fund Services Inc.
On January 18, 2018, the US Securities & Exchange Commission released a staff letter entitled, “Engaging on Fund Innovation and Cryptocurrency related holdings.” Dalia Blass, Director of the Division of Investment Management, wrote on behalf of the commission, “We believe, however, that there are a number of significant investor protection issues that need to be examined before sponsors begin offering these funds to retail investors.” Letters such as these are a warning to private fund managers and sponsors that should use such communications as navigational beacons, providing important, albeit, limited guidance for them to use as they (and financial vendors providing operational support services) begin to establish a framework for an industry ‘Best Practice.’
“Fools rush in where angels fear to tread.” ~ Alexander Pope, An Essay on Criticism
Pay heed to the issues described by Ms. Blass in her letter to commission staffers such as, “various concerns regarding transparency of information, trading, valuation and other matters related to the nature of the underlying assets.” It is common practice for private investment partnerships that trade in traditional securities to post valuations and accept subscriptions and redemptions monthly, or quarterly. Given the fact these markets trade around the clock on multiple exchanges with no real third party verifications except for screen shots, it would be advised that a clear procedural process is in place that is consistent and reliable. US Eastern Time might not be a practical option for when month-end or quarter-end pricing is derived, but rather UTC time. UTC time is the predominantly used delineation for the close of business in the largest and respected data providers of pricing in the cryptocurrency markets. Managers should be able to defend their valuation policies. How can they be sure they are creating a ‘best practices’ environment?
- Create an analysis of fair value based upon their experience and explain how they arrived at their valuation with a clear and defined valuation methodology.
- Provide various sources and support to validate their belief, analysis, and the valuation methodology used.
- Be able to cogently describe the rational as to why the analysis is reasonable and represents ‘best practices’ for the fair valuation of these investments.
Third party vendors can derive pricing from a third-party, but it must be understood that counter-party verification is not available (tough to get feeds directly from an exchange, most are currently relying on price reporting from websites like www.coinmarket.com). Ultimately, vendors such as auditors and administrators are going to be extremely reticent to provide any real assistance in aiding the manager in his or her process of valuation for they are paid to be the fiduciary of the ‘fund’ entity, and this means they must be representing the interests of the Limited Partners, Shareholders, or whatever form make-up the beneficiaries of the funds being managed.
From the AICPA website: “While an accountant normally is not considered to be a fiduciary to his or her clients, the AICPA Professional Code of Conduct embodies standards of conduct which are closely analogous to a fiduciary relationship—objectivity, integrity, free of conflicts of interest and truthfulness.“
While private investment funds might only offer monthly or quarterly liquidity, what procedures are in place – and expressly disclosed – to investors that might accomplish the various similarities to certain early stage venture investments that might exist with ICO investments. ICO’s are initially illiquid, unable to find a reliable quote, difficult to value or even know with certainty that the investment will be at all successful and not die a terrible death of worthlessness. There are several options that security attorneys have in their arsenal of weapons to deal with such situations, but they should be addressed in the offering memorandum (sidecar arrangements, various series of interests or shares, ect). Investors must understand what implications are of such liquidity traps and the potential for their assets to be frozen and the risks implied in ICOs.
A wonderful poem by Rudyard Kipling:
“If you can make one heap of all your winnings
And risk it on one turn of pitch-and-toss,
And lose, and start again at your beginnings
And never breathe a word about your loss”
While private funds might not be bound by 22-e, working to establish a Best Practices approach would suggest that every measure must be taken to anticipate the problems and subsequent solutions that could exist for funds operating in the Cryptocurrency space. Is it possible to pay-out in kind? Is there a plan in case this is necessary? Are you employing third-party administrators?
“The mind of a wise man is the safest custody of secrets.” ~ Ali ibn Abi Talib
That might ring true philosophically, but what are you going to do from a practical stand when you have to have a process by which those private keys are held by a custodian and/or custodial process for safekeeping… can they be insured for loss? Can you utilize a trust company? Surprisingly, there IS a US trust company that is developing best practices for digital currency, holding them for institutions and individuals and IRAs alike (since IRS Notice 2014-2). There are limitations to the types of digital currencies they can custody, but there are becoming traditional solutions for this industry that are actually shocking when you think about how neophyte it remains. Sadly, the options are few and practically, I’m not sure that they are satisfactory for the broad and increasingly complicated needs that these new funds possess/will possess.
Eric Jacobs is Managing Member of Essential Fund Services Inc. and has spent more than a quarter century working in the financial services industry. Mr. Jacobs is the founder and former portfolio manager for Miller & Jacobs Capital LLC, a formerly $850 million Asset Management Firm specializing in alternative hedge fund’s (such as the Acadia Fund) as well as traditional, mutual fund products, structured, asset backed products and consulting in the financial services industry.