Adjunct Professor Arina Shulga wrote an op-ed in Bloomberg Law about the consequences that investment managers may face if they disregard securities laws when raising capital for their fund even if the fund is a crypto fund.
On Dec. 7, 2018, the Securities and Exchange Commission issued a cease-and-desist order (Order) against CoinAlpha Advisors LLC (CoinAlpha) for failure to comply with the provisions of the Securities Act of 1933, as amended, while raising capital. CoinAlpha was a Delaware LLC, created to act as the managing member of, and manager to, CoinAlpha Falcon LP, a Delaware limited partnership (Fund) that invested in crypto assets.
CoinAlpha raised funds from 22 investors, but failed to qualify the offering under either Rule 506(b) or Rule 506(c) exemption from the registration requirements of the Securities Act (or any other available exemption).
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Rule 506(b) is a non-exclusive “safe harbor” for compliance with Section 4(a)(2) of the Securities Act that provides a statutory exemption for “transactions by an issuer not involving any public offering.” Since Section 4(a)(2) does not on its own provide sufficient guidance as to how to conduct a private placement, Rule 506(b) was promulgated with the specific purpose of providing a well-defined path to conducting private placements in compliance with Section 4(a)(2).
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The rule allows an issuer to raise unlimited amount of funds from an unlimited number of accredited investors and up to 35 unaccredited but financially sophisticated investors. Certain disclosures must be provided to unaccredited investors. It is important to remember that the rule prohibits general solicitation and advertising. The issuer can only reach out to investors with whom it has pre-existing substantive relationships when raising funds.
Finally, the issuer must reasonably believe that the investors are accredited or financially sophisticated, generally relying on investor questionnaires and representations in the purchase agreements.
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Any securities lawyer would know the difference between the two rules and how to comply with each. As the Order shows, failing to obtain competent legal advice when conducting a private placement of securities can lead to devastating and embarrassing results of having to close the entire fund.
Twenty-two investors from five states invested a total of $608,491 into the Fund. All of them turned out to be accredited investors. However, the manner in which CoinAlpha conducted the offering did not qualify for either of the exemptions.
Although the Fund filed Form D with the SEC stating it was conducting an offering pursuant to Rule 506(b), the offering did not comply with Rule 506(b) because CoinAlpha engaged in general solicitation of interest in the offering through its website, which anyone could access without a password.
Further, CoinAlpha advertised the offering on its blog, through media interviews, and at industry-specific conferences. Once the issuer started publicizing its offering, Rule 506(b) could no longer be relied on. On the other hand, Rule 506(c), which allows issuers to use general solicitation and advertising, was still available. However, CoinAlpha failed to qualify under Rule 506(c) exemption as well because it did not take reasonable steps to verify the accreditor investor status.