I am getting quite a few questions lately from venture capital managers about Bitcoin, blockchain and token based offerings. The questions center primarily around the permissibility of the fund participating in these sorts of investments given mandates, purpose clauses and even the core legality of doing so; and secondarily about related matters such as tax and regulatory issues that may arise under governing documents or otherwise.
These are good questions, in an emerging and unsettled area mostly without clear “black and white” legal guidance. The lines of inquiry and attendant responses can be categorized depending on the nature of the activity being asked about. The easiest question to answer relates to investments in virtual currency or blockchain servicing companies, where there is no actual trading of virtual currencies by the fund and the securities being acquired are of the traditional nature (i.e., not token based). While this sector is certainly subject to risk of wild valuation swings, especially given the new and unsettled nature of cryptocurrencies themselves, making this sort of investment would not seem to be especially problematic legally as long as the general mandate of the fund in question would support it. If that was not the case, say in the case of a fund held out as a health care fund now dabbling in these sorts of investments, you’d have the typical misrepresentation concerns, but those concerns wouldn’t be related to the nature of the chosen investments, but only to the fact that they were outside the promised hunting license of the underlying fund.
That leaves the two more difficult questions I am getting: can the fund invest by way of token offerings, and can the fund invest directly in cryptocurrency. These questions bring up a myriad of issues to consider, with the analysis in some cases being similar as between token investments and direct cryptocurrency investments, and in some cases distinct. A few of the more important issues to think about follow.
First, does the LPA permit this and/or would it be inconsistent with the way the fund was marketed? Most LPAs I work with are very broad in defining the types of investments venture funds can make, but those definitions, while broad, usually revolve around some view that the fund will be acquiring “securities”. That is often lowercase, and may or may not be best read to correlate to, say, the SEC’s view of what constitutes securities (though, that would seem to be at least instructive in the analysis as to issues in the United States). A typical clause might say the fund can trade in “securities of every kind and nature and rights and options with respect thereto, including stock, notes, bonds, debentures, partnership interests, interests in limited liability companies and evidence of indebtedness”.
If tokens and/or cryptocurrencies are securities, this would seem to be well covered by that language. But this issue is somewhat unsettled right now, at least as related to the strict legal definition. So, I have seen managers starting new funds endeavor to be more specific, and for existing funds, managers have to debate whether they should seek an amendment to clarify the investment mandate. A typical addition to the above might expand the definition of permissible investments to include “investments in cryptocurrencies, decentralized application tokens and protocol tokens, blockchain-based assets and other cryptofinance and digital assets, or instruments for the purchase of such, whether issued in a private or public transaction”. Outside of the contracts, from a marketing standpoint, query whether these investments would in any way be inconsistent with the described offering, and going forward if these investments are contemplated, the term sheets and other offering descriptions that may go into say a PPM should be fulsome in describing the potential activity. Common general risk factors (for example addressing the potential for total loss of principal) may be satisfactory for near-term limited token or cryptocurrency investing activity, but going forward consider well tailored, specific risk factors to this sort of undertaking.
Second, the question of legality arises. China, South Korea and Switzerland have already expressly outlawed token offerings and in some cases, activities related to cryptocurrencies like exchanges and mining operations. Other countries seem actively more amenable to these new concepts, and in yet other countries, particularly the United States, the verdict is still mostly out. Care should be taken to limit activities to places where, at least as of the time of investment, the consummation of the token or cryptocurrency acquisition is lawful (with an attendant plan to react quickly in some manner if there is any change in law, being prepared even for nullification of prior transactions).
Next in line to consider are related legal and tax issues, and there are several of them. For starters, most venture capital funds rely on the “venture capital exemption” from investment adviser registration which allows for only 20% of capital to be in non-qualifying investments. Token investments are very likely to fail, and direct cryptocurrency investments certainly do fail, the test to be qualifying investments, and all of the above should best be thought of as non-qualifying, added with other non-qualifying investments, and a determination made as to adherence to the 20% rule, with recognition that exceeding this will trigger a registration requirement if the fund in question is inside the SEC’s jurisdiction. Funds subject to similar regimes in other localities should consider local laws (in particular Cayman Islands based funds, even where subject to SEC oversight, should be mindful of CIMA registration requirements which might be triggered in certain cases).
The list of related legal and tax issues grows longer when considering direct cryptocurrency investing. Much of this is unsettled, but care should be taken to analyze whether this might be commodity trading and thus subject the manager or fund to CFTC oversight; whether there can be negative UBTI and/or ECI implications arising because of regular trading in cryptocurrencies which could lead to a finding of being engaged in a trade or business of doing so; and where applicable to a particular fund, VCOC/ERISA issues (inasmuch as “management rights” are certainly not able to be exercised in respect of cryptocurrencies).
Third and finally, I have been counseling my clients to be extremely mindful of client relations. This is all a risky area where today’s roses may be tomorrow’s ashes. I urge managers I work with to be extremely mindful of this and not just to assume that investors will be thrilled for the fund to be “on the cutting edge” of these sorts of undertakings. With token sales, I worry about reputational issues if investments are made and later invalidated by authorities or courts. With direct cryptocurrency investments, the situation seems worse to me. The theory behind public securities limits in venture funds comes to mind. Investors typically are not thrilled about open market purchases, at least not speculatively where there is no particular inside expertise (i.e., a venture fund investing in IBM is going to be disfavored – why would LPs pay fee and carry on this investment, which they could make themselves – but holding public securities, or even purchasing more, where the fund backed the company in its private days and has a well formulated understanding of the market and the company’s position in it may be viewed as fine). It occurs to me that direct cryptocurrency investing feels much more like pure speculation than some area where the fund can propose that its expertise benefits the LPs so that they get a “better deal” than if they invested directly. I’m urging my clients to be mindful and transparent with investors regarding these issues, so that if things do go sideways, they aren’t out on a limb. Or at least a long one.