Despite the recent downswing in cryptocurrency markets, investor interest has not waned. An increasing number of investment funds is emerging that focus on cryptocurrencies including tokens from Initial Coin Offerings or ICOs. Indeed, some have even projected that the number of crypto-focused hedge funds—currently around 150—will double or triple within the next year. Anyone who is involved or plans to become involved with operating, managing, or marketing such crypto-funds must remain vigilant, as the Securities and Exchange Commission's interest in cryptocurrency and crypto-funds has also increased.

On February 7, 2018, the SEC Office of Compliance Inspections and Examinations (“OCIE”) announced its 2018 National Exam Program Examination Priorities includes, for the first time, cryptocurrency, ICOs, blockchain, and related secondary market trading. Per the OCIE:

The cryptocurrency and ICO markets have grown rapidly and present a number of risks for retail investors. Along with the growth of these products and markets, the number of broker-dealers and investment advisers engaged in this space continues to grow as well. We will continue to monitor the sale of these products, and where the products are securities, examine for regulatory compliance.

Areas of focus will include, among other things, whether financial professionals maintain adequate controls and safeguards to protect these assets from theft or misappropriation, and whether financial professionals are providing investors with disclosure about the risks associated with these investments, including the risk of investment losses, liquidity risks, price volatility, and potential fraud.

The OCIE announcement echoes SEC Chairman Jay Clayton's recent testimony before the U.S. Senate Committee on Banking, Housing, and Urban Affairs. On February 6, 2018, the Chairman testified that, in the SEC's view, “to date ICOs have largely been” securities. Per Chairman Clayton, “if a cryptocurrency, or a product with its value tied to one or more cryptocurrencies, is a security, its promoters cannot make offers or sales unless they comply with the registration and other requirements under our federal securities laws.” Thus, the Chairman has unequivocally warned “[b]rokers, dealers and other market participants that . . . allow customers to purchase cryptocurrencies (including on margin) or otherwise use cryptocurrencies to facilitate securities transactions” that they “should exercise particular caution, including ensuring that their cryptocurrency activities are not undermining their anti-money laundering and know-your-customer obligations.”

Chairman Clayton also specifically addressed crypto-funds on February 6, explaining that the SEC will not “permit ETFs [Exhange-Traded Funds] and other retail investor-oriented funds to invest in cryptocurrencies” until various assurances are provided that they can operate “in a manner consistent with their obligations under the federal securities laws.” Specifically, the Chairman identified “issues around liquidity, valuation and custody of the funds' holdings, as well as creation, redemption and arbitrage in the ETF Space.”

In a letter dated January 18, 2018 to the Investment Company Institute and the Securities Industry and Financial Markets Association, Dalia Bass, Director of SEC's Division of Investment Management, provided more insight into the crypto-fund “issues” mentioned by Chairman Clayton at his testimony. With respect to concerns about crypto-fund valuation, Director Bass noted:

• How could crypto-funds have ample information to adequately value cryptocurrencies, given their volatility, the fragmentation and general lack of regulation of underlying cryptocurrency markets, and the nascent state of the cryptocurrency futures markets?

• How would crypto-funds develop and implement policies and procedures to value, and in many cases “fair value,” cryptocurrency-related products?

• How would differences among various types of cryptocurrencies impact crypto-funds' valuation and accounting policies?

With respect to crypto-fund liquidity concerns, Director Bass asked:

• What steps would crypto-funds take to assure that they would have sufficiently liquid assets to meet redemptions daily?

• How would crypto-funds classify liquidity for purposes of fund liquidity rule 22e-4?

• Could crypto-funds conduct a meaningful market depth analysis?

With respect to custody concerns, Director Bass noted:

• How would a crypto-fund satisfy the custody requirements of the 1940 Act and relevant rules given the virtual nature of tokens?

• How would a crypto-fund validate existence, exclusive ownership and software functionality of private cryptocurrency keys and other ownership records?

• How would the potential for hacks of digital wallets impact crypto-funds' safekeeping under the 1940 Act?

As for arbitrage concerns for crypto-ETFs, Director Bass asked:

• How would a crypto-ETF set and maintain a market price that does not deviate materially from its NAV?

• How would volatility-based trading halts on a cryptocurrency futures market impact arbitrage?

• Similarly, how would the shutdown of a cryptocurrency exchange impact market price or arbitrage mechanism?

Given the heightened emphasis of the SEC on cryptocurrency and crypto-funds this year, it is probable that the SEC will investigate and/or litigate against Registered Investment Advisers associated with crypto- funds. But what might these enforcement actions look like, and what might the consequences be? Despite the seeming novelty of cryptocurrencies as fund assets, such assets will present fund managers with many of the same regulatory issues they currently face with other private, illiquid, or volatile assets. As a result, last year's SEC enforcement actions against fund advisers may offer the best indications of what the SEC's enforcement actions will look like in the cryptocurrency fund area.

Just in the second half of 2017, the SEC continued its long history of aggressive fund adviser scrutiny with enforcement actions alleging:

• Inflation of the value of illiquid, private fund investments despite a lack of valuation training or experience;
• Use of inappropriate assumptions to value private fund assets based on a discounted cash flow analysis;
• Use of fund money to pay portfolio investment transaction expenses that the adviser allegedly should have paid;
• Retention by the adviser of money received from portfolio companies for providing consulting and advisory services

In 2018, the SEC will waste no time changing gears, and fund advisers contemplating including cryptocurrency investments in funds they manage would do well to familiarize themselves with these and related SEC hot button issues.

Nicolas Morgan is a partner in the Investigations and White Collar Defense practice at Paul Hastings and based in the firm's Los Angeles office. He focuses his practice on complex securities litigation in state and federal courts and representations involving government investigations and white-collar crime allegations levied against individuals and businesses.

Adam Reich is an associate in the Litigation practice of Paul Hastings and is based in the firm's Los Angeles office. His practice is principally concentrated in complex commercial litigation matters.