There are over 4,000 words in the U.S. Securities and Exchange Commission’s rule describing all the documentation that a registered investment advisor needs to maintain.
And more and more venture capital firms investing in the blockchain industry are getting large enough that they have to become registered investment advisors (RIAs), and this dramatically increases their compliance obligations. This has a privacy impact for companies invested in by these firms, to a degree that many entrepreneurs may not yet appreciate.
“Books and records requirements that track every trade and investment that you’re doing, that needs to be available to the SEC if they decide to audit you” Adam Tope, a partner at DLA Piper, told The Defiant. “It’s basically just like being any hedge fund.” Tope has been working with all kinds of crypto funds for years now.
An investment adviser is someone who provides investment advice or analysis of securities for pay. The defining law here is the Investment Advisers Act of 1940. Under certain conditions, some of them have to be registered with the Securities and Exchange Commission (SEC). A variety of entities have to do this, but the ones we care about are venture firms that back blockchain companies.
Any founder who has received funding from crypto hedge funds should probably check to see if those firms have taken steps to become RIAs. If they have, it could change the nature of investor/investee communications in an important way, because everything that transpires in writing between them should be thought of as a permanent record available for review by securities regulators.
“My view — even pre-crypto — is if you say something to someone or write something to someone, you should expect that the world may see it,” Andy Bromberg, CEO of DeFi savings platform Eco and former head of CoinList, told The Defiant. “I think that anyone that’s under an assumption of that not being the case is probably going to be burned at some point.”
Eco raised $86M in 2021 across two rounds, with participation by firms like Andreessen-Horowitz and Lightspeed Ventures.
Many entrepreneurs may not have considered the full implications of compliance obligations as scrutiny on the crypto space increases as it grows.
Arjun Bhuptani, the founder of the blockchain interoperability project, Connext, said that these issues have been relevant to conversations he’s had with investors. “I’ve talked to funds that have said this is why you should raise from us and not them,” he said. “I do agree that a lot of founders are not really aware. I only found out about it because there were funds that pitched us with this in mind.”
Connext raised $12M from 1kx and Consensys Mesh last year.
Inevitable
If the term RIA sounds familiar, it may be because Andreessen-Horowitz made news in 2019 when it made the shift. Since then, funds that are much less famous in crypto have done the same, usually because the rules made it mandatory for crypto-oriented firms, even if a lot of traditional venture firms are exempt.
Two features of crypto venture funds are forcing them to become RIAs: success and tokens.
The classic venture fund buys chunks of companies that aren’t tradeable on public markets. That’s not true for funds that back crypto companies, however. These firms almost always end up buying crypto coins and crypto tokens (often alongside equity). Many of them also have liquid strategies, where they trade on the open market. Coins and tokens are liquid instruments that many attorneys would advise clients to treat as if they were securities, at least for now.
Further, 2021 was a stellar year for crypto. A lot of these firms have grown immensely — perhaps much bigger than they might have reasonably expected at launch. In fact, they have done so well that they now have more than $150M in assets under management.
At that point, without an exemption, a firm in this space is required to become an RIA.
This is an interesting delineation between crypto’s VCs and the traditional ones that have served the tech industry so far. All those tokens and coins change the view of regulators.
At least, that’s how most see it. There are rumors of funds out there who have chosen to operate as if tokens aren’t securities. For his part, Tope does not recommend this approach.
Why Does It Matter?
Privacy may be a big deal in crypto, but it’s not such a big deal to the SEC.
RIAs have to hold onto all kinds of records. The primary concern for the SEC, Tope explained, is how funds are marketing and representing themselves, how they are managing it, what kind of rules they have for their staff to make trades, if they have a compliance officer, etc. Mostly, he said, that’s what they care about: are they making appropriate checks that their limited partners are qualified and are they representing their fund accurately to customers.
But crypto funds are starting to worry about another audit trail: how they talk to the companies that they invest in.
The SEC hitting up investors for records like these is not a common occurrence for funds yet, according to Tope. “It doesn’t happen a lot, but it has happened more often more recently,” he said. “They expect you to give them everything you got.”
The Defiant spoke to four different funds, none of which wanted to speak on the record. All noted that they have begun keeping many more records of their communications, including communication with the companies they have funded.
“These requirements are particularly strong in the US, and I think a lot of non-US founders aren’t aware of what these requirements look like,” Bhuptani said.
This extends into records that folks might not think of as formal, such as Telegram.
“I do think people perceive different media differently. You can just see that in how casually people write. The same person writes much more formally in an email than on Telegram,” Bromberg said.
Most venture firms have private Telegram channels for groups of their investors. In those, they can strategize and problem-solve together. Entrepreneurs might think of it as a private space, but once the fund running it has risen to the RIA status, founders should probably assume that channels are being archived, just in case regulators ever want to see those communications.
“Being careful about how you communicate is not an indication that you are doing something wrong. You just aren’t aware of what the future may hold or how those communications may be used,” Bhuptani said.
The SEC did not reply to The Defiant’s requests to discuss these matters.
Blurred Lines
Crypto is a 24/7 environment. People’s private and public lives get very murky in this space.
Friends become business partners. People work on their companies while also making personal trades based on rumors circulating around the scene. It wouldn’t even be fair to say they do these things “on the side.” It’s all of a piece in crypto.
But one fund we spoke to said that it’s starting to think seriously about getting its staff business phones and asking everyone to spin up all-new identities on messaging apps so there can be a clear delineation between business and personal.
“This feels like the Nth microcosm of a nascent industry rediscovering the practices of the industry before it,” Bromberg said. The two-phone model has been pretty normal elsewhere for a long time. This is a case of crypto playing catch up to the world, when usually crypto sees the rest of the world playing catch up to it.
For startups, which aren’t directly worrying about compliance in quite the same way, it’s worth considering the fact that everything they write to RIA staff is getting readily logged and indexed for potential review by regulators. This isn’t to say that they are looking in real-time, but it also means that those conversations might one day be reviewed by outsiders.
“It’s not something we’ve been too actively concerned about,” Bhuptani said. “I can see how it might be concerning for projects that are treading a line around regulation.”
This could be more salient in crypto for another reason: we have had reports that regulators are gathering information about various projects. That may or may not lead to regulatory action later, and we have no way of knowing if regulators would look to funds’ records as a source of information in making a case.
But it might. Caution may be warranted.
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