Sadis Obtains Termination of S.E.C. Investigation of Blockchain Venture Capital Fund
LESSONS FOR CRYPTOCURRENCY AND BLOCKCHAIN-FOCUSED INVESTMENT ADVISORS
Sadis & Goldberg (“Sadis”) recently obtained a favorable termination of an SEC investigation into the valuation practices of a Blockchain-focused Venture Capital Fund (the “Fund”). The SEC investigation focused on the Fund’s practice of valuing a direct cryptocurrency investment at its current average trading price – instead of the original private offering price. The SEC was concerned this method conflicted with the Fund’s valuation of other investments using private offering prices. Sadis used an early, proactive approach to persuade the Staff to terminate the investigation. This offers many lessons for Cryptocurrency and Blockchain investment advisers dealing with SEC and other regulators.
Sadis persuaded the SEC Staff to terminate the investigation by quickly responding to key concerns, including by providing: (i) a White Paper detailing the factual and legal arguments supporting the Fund’s valuations, (ii) proof that the client’s valuations were not inconsistent with Generally Accepted Accounting Principles (“GAAP”), particularly since the Financial Accounting Standards Board (“FASB”) has yet to provide definitive guidance for valuing digital assets, and (iii) evidence that the Fund’s administrator found the valuation methodology reasonable; and (iv) a summary of the Fund’s disclosure of its valuation methodology to investors. In particular:
White Papers Can Effectively Present Defenses to an Investigation: Sadis presented a detailed “White Paper” setting forth factual, legal and accounting arguments for the Fund’s valuations early in the investigation. The White Paper quickly drew the SEC Staff’s attention to the client’s factual and legal arguments, before the Staff was so deep into its investigation that it was already drawing negative conclusions. Clients usually benefit from investing in a White Paper or other presentations to the S.E.C., because they cause the Staff to spend more time thinking about a client’s defenses – at a time when the Staff is still able to be persuaded. The SEC Enforcement Manual contemplates White Papers.
Lack of FASB Definitive Standards on Valuing Digital Assets: Sadis also showed that the Fund’s valuation practice was not inconsistent with GAAP, particularly because the FASB has not yet adopted rules for valuing digital assets. Instead, there is only non-authoritative guidance from the AICPA suggesting that some companies should account for cryptocurrency as an intangible asset under ASC350. [1] But that same guidance states that investment firms can make subsequent valuations of digital assets at fair value under ASC 946, i.e., the expected exit price in a market transaction. Using this standard, average cryptocurrency trading prices arguably is a reasonable valuation method. Note: The FASB is expected to provide digital asset valuation standards soon. Investment advisers focused on Cryptocurrency and/or Blockchain should be prepared for these new standards.
Auditor or Administrator Support for a Valuation Practice Can Help: An important fact for the Fund was that it had worked with its Fund Administrator in finalizing and disclosing the average-trading-price valuation methodology. Thus, the Fund had evidence that the Administrator found the valuation practice to be reasonable. Although Auditor or Administrator valuation approval is not legally dispositive, it does help show that an investment adviser is acting in good faith towards investors, and is trying to be transparent. Also, it can make it harder for the S.E.C. to bring a winning case.
Disclosures Make a Difference: For any investment adviser, robust disclosures and warnings in an investment fund’s governing documents are critical for legal compliance and to avoid liability. Here, Sadis highlighted that the Fund disclosed its valuation practice of using average trading prices for cryptocurrency in its quarterly reporting to investors – which helped prove good faith. Further, Sadis highlighted warnings in the Fund’s Offering Memorandum that (i) the valuation of assets would be inherently subjective because the assets are difficult to value, and (ii) valuations would be determined in good faith with broad discretion. Sadis also emphasized that the Fund’s governing documents did not commit the Fund to any specific valuation methodology.
The recent favorable termination of an SEC investigation into a Blockchain Venture Capital Fund’s valuation provides many lessons for investment advisers – particularly those in the digital asset space – about how to successfully handle government investigations. First, taking a proactive approach of presenting defenses relatively early in an investigation (through a White Paper or attorney proffer) can be very effective at persuading regulators. Second, the relatively unsettled legal framework for digital assets offers many opportunities to successfully defend against an investigation, and avoid legal liability. Third, discussing and evaluating a fund’s valuation practices with auditors and administrators is not just good investment management – it also opens the door to an additional defense if a regulator later focuses on valuation practices. Finally, when in doubt, robust disclosure is a sure defense against regulatory and legal liability.
Sam Lieberman, Co-Head of Sadis’s Litigation Practice, led the Sadis & Goldberg team that obtained termination of this investigation, with help from Michael Davis and Desi Ilieva. If you have any questions about this Alert, any cryptocurrency or blockchain-related matter, or any regulatory investigation, please contact Sam Lieberman at 212-573-8164 or slieberman@sadis.com.
