The US Securities and Exchange Commission (“SEC”) and the Commodity Futures Trading Commission (the “Commissions”) recently proposed amendments to Form PF that address, among other things, the growing popularity of digital asset strategies among new and existing private funds managed by registered investment advisers and the increasing volatility these assets have seen in recent years.1 With respect to digital assets, the jointly proposed amendments were designed to help the Commissions collect more accurate information on funds’ exposures to digital assets in order to understand better their overall market exposures.
The proposed amendments would also modify many other areas of Form PF reporting, generally aimed at standardizing and increasing the quality of information reported across funds and advisers, changes that are not addressed in this Legal Update. As a general matter, the proposal is intended to bolster the SEC’s regulatory oversight of private fund advisers and investor protection efforts.
The Commissions proposed amendments to the form’s general instructions as well as to section 1 of Form PF (which would apply to all Form PF filers) and to section 2 of Form PF (which would apply to large hedge fund advisers who advise qualifying hedge funds with a net asset value of at least $500 million). The Commissions recognized that since Form PF was adopted in 2011, certain investment strategies, including digital asset strategies, have become more common, and existing reporting may not identify fully the potential risks inherent to investments in these novel products. If the proposal is adopted, the Commissions believe the Form would be better aligned with current market realities and recent trends.
Summary of Digital Asset Proposals
The Commissions proposed four primary changes to Form PF relative to digital assets, each summarized below.
- Digital Asset Definition – First, to avoid ambiguity and to ensure that private fund advisers report digital asset strategies accurately going forward, the Commissions proposed to define “digital asset” as “an asset that is issued and/or transferred using distributed ledger or blockchain technology (‘distributed ledger technology’), including, but not limited to, so-called ‘virtual currencies,’ ‘coins,’ and ‘tokens.’” The Commissions added that they view “crypto assets” as synonymous with “digital assets” since these terms are commonly referred to interchangeably. The Commissions also indicated they wanted their definition of “digital assets” to align with the SEC’s recent statement on digital assets2 to provide a consistent understanding of the type of assets the Commissions intend to address.
- Cash and Cash Equivalents Definition – Second, the Commissions proposed to amend the definition of “cash and cash equivalents” so it would explicitly direct advisers not to include any digital assets when reporting cash and cash equivalents. The Commissions noted that this proposed amendment was designed to help facilitate accurate reporting by ensuring that the categories of “cash and cash equivalents” and “digital assets” are clearly distinct from one another.
- Hedge Fund Strategies in Section 1c – Third, the Commissions proposed to amend Section 1c of Form PF to better address how advisers report hedge fund investment strategies by adding reporting categories for strategies that have become more commonly pursued by hedge funds since Form PF was adopted, such as digital asset strategies. The Commissions noted that currently advisers typically report information regarding these strategies in the “other” category, resulting in less robust Form PF data for analysis. Accordingly, in Form PF section 1c, the proposal would require hedge funds to report whether their investment strategy includes digital assets. The additional categories were designed to improve reporting quality and data comparability across advisers.
- Sub-Asset Classes for Large Advisers to Hedge Funds in Section 2b – Fourth, the Commissions proposed to amend Section 2b of Form PF to require large advisers to qualifying hedge funds to report their total exposures to a new “digital assets” sub-asset class. This change is part of a broader effort to require reporting based on “instrument type” within sub-asset classes to identify whether a fund’s investment exposure is achieved through cash or physical investment exposure, through derivatives or other synthetic positions, or indirectly (e.g., through a pooled investment or a private fund). These amendments would further require advisers to calculate and report the “adjusted exposure” of long and short positions for each sub-asset class, such as digital assets.
Requests for Comment Concerning Digital Assets
The Commissions requested comment on a number of items related to the amendments concerning digital assets, including whether the definition of “digital asset” as proposed would accurately identify the digital assets held by funds3 and whether more specific disclosure of what each digital asset represents is merited.4 For example, the Commissions asked whether advisers should be required to disclose the rights that the digital asset provides to the holder and whether Form PF should distinguish between digital assets that represent an ability to convert or exchange the digital asset for fiat currency or another asset (including another digital asset) and those that do not represent such a right to convert or exchange.5
The proposed amendments reflect the continued federal regulatory focus on digital assets and the growing popularity of digital asset strategies and related activities. Following SEC Chair Gary Gensler’s recent comments that he believed the “vast majority” of crypto tokens are securities and that investors deserve to be protected against “fraud and manipulation” in the digital assets marketplace,6 it is increasingly clear that the regulatory focus on digital assets will only intensify in the coming months. These proposed amendments may serve as a first step in a long procession of regulatory action aimed at bringing digital assets squarely within the regulatory grasp of the Commissions.
Additional regulatory reporting regarding digital asset strategies and exposures, like any regulatory reporting enhancements, will likely result in increased regulatory scrutiny, whether by examination, enforcement, guidance or other methods. Applying existing regulatory requirements to novel asset classes and strategies can be challenging, to say the least. The manner in which advisers have chosen to navigate compliance with respect to novel asset classes and strategies historically has been scrutinized by regulators. Given the tremendous regulatory focus on digital assets, the same amount of scrutiny, if not more, is likely in our view.
The proposal remains open for public comment until October 11, 2022.
1 See Commodity Futures Trading Commission & Securities and Exchange Commission, Release No. IA-6083, Form PF; Reporting Requirements for All Filers and Large Hedge Fund Advisers (Aug. 10, 2022), https://www.sec.gov/rules/proposed/2022/ia-6083.pdf [hereinafter “Release No. IA-6083”].
2 See Custody of Digital Asset Securities by Special Purpose Broker-Dealers, Exchange Act Release No. 90788 (Dec. 23, 2020), https://www.govinfo.gov/content/pkg/FR-2021-02-26/pdf/2020-28847.pdf at n.1.
6 Securities and Exchange Commission, Speech by Chair Gary Gensler, “Kennedy and Crypto” (Sept. 8, 2022), https://www.sec.gov/news/speech/gensler-sec-speaks-090822