Part IV - An X-Ray of the Fund’s M&A and Subscription/Redemption Agreement

A. The Fund’s Constitution

An Incubator Fund in the BVI is incorporated as a “company limited by shares” (the “Company”): a standard limited company which has been upgraded using a Special Resolution that adopts amended and restated Memorandum and Articles of Association (M&A) for the Company.

We have shared a template M&A here for ease of reference.

This M&A put the legal mechanism in place that deals with all the rights and obligations of the Directors and Shareholders in the Fund.

When Managers also invest their own money in their Fund to have “skin in the game”, under the M&A they will be treated like any Shareholder.

1. The Fund’s capital structure

The M&A authorize the Company to issue a maximum of 50,000 Shares comprised of a maximum of 50,000 no par value participating shares designated as Ordinary Shares.1

This capital structure often confuses clients.

• First, the 50,000 shares are chosen in light of a tax threshold since BVI applies higher annual dues for companies with an authorized capital above 50,000 shares. The number itself is in itself not meaningful.
• Second, the 50,000 Shares are authorized capital, not issued capital. Think about authorized capital as Shares held in reserve, ready to be issued when more shareholders come in. If authorized capital would be limited to issued Shares, a capital increase would be required each time a new shareholder comes in. Furthermore, Shares can be fractionalized with the same rights as whole Shares so there no risk the Company will be short of Shares.
• Finally, the Shares are authorized without par value. In other words they have no nominal value, which is different from the actual value the shares will be priced at when the Fund launches. As seen in Part III, this Share price can be set at any level during the Initial Offer Period. Once the Fund trades, the Share price will reflect the Fund’s Net Asset Value per Share which, simplified, is the aggregate value of the assets in the Fund (after all expenses including fees) divided by the total number of Shares outstanding at the time the NAV is calculated.

The Fund shall keep a register of Shareholders containing:

1. the names and addresses of the persons who hold Shares;
2. the number of each Class and Series held by each Shareholder;
3. the date on which the name of each Shareholder was entered in the register of members; and
4. the date on which any person ceased to be a Shareholder.

However the M&A conveniently does away with Share certificates which would be impractical for a Company that continuously issues and allows for redemption of its Shares.

The above “register” is an internal document and can be in any form the Directors approve2, and could therefore include distributed ledger technology (See Part V).

2. Redeeming features

The key characteristic of the Fund’s Shares is that they are redeemable.

Redemption is in essence the right granted under the M&A for the Company to “purchase, redeem or otherwise acquire” its own Shares. In other words, when a Shareholder redeems, he/she sells their Shares back to the Fund.

This typically happens when an investor (Shareholder) wants to come out of the Fund (voluntary redemption), but can also be forced upon a Shareholder (compulsory redemption).

Voluntary Redemptions

In the former case of a voluntary redemption, the Investor will need to make a valid Redemption Request which will take effect from any Redemption Day:

• Typically, such Redemption Requests must be received by the Company (or its authorized agent) at least 30 Business Days prior to the relevant Redemption Day, however we have seen Funds with 90 or even 180 days’ notice periods.

• Typically, the Fund reserves the right to “gate” redemptions, for instance when the aggregate redemptions represent more than more than 10 per cent of the total Net Asset Value of the Fund. In such circumstances, the Managers may pro rata “cut down” each redemption amount and then carry forward the balance for redemption to each succeeding Redemption Day until each request has been completed in full.

• Some Funds also impose minimum redemption amounts per notice.

• Potentially more aggravating for investors is when their redemption would bring the value of their residual holding in the Fund under a minimum specified by the Managers. Such Redemption Request would then result in a partial redemption up to the minimum amount.

• The Redemption Price is the Net Asset Value per Share of the Shares (or the Series to which the Shares belongs), calculated as at the Valuation Day immediately preceding the Redemption Day.

  • Redemption Day means the last Business Day of every month or the first Business day of the following month, as the case may be, in the case of monthly redemption.

  • Valuation Day means close of business on the Business Day immediately preceding each Redemption Day or the last Business Day of each month as the case may be.

• The directors may adjust the Redemption Price by applying the redemption fee specified in the Term Sheet. This fee is then deducted from the redemption proceeds.

• Redemptions can be paid in US Dollars or in any other currency as the Directors may determine, which would include digital assets and crypto currency.

• The M&A also deals with circumstances in which the Fund may suspend payment of redemption proceeds, including when the Fund cannot be adequately valued. Clauses of this natured have greatly angered investors in traditional hedge funds at the time of the mortgage crisis of 2008 however they have survived and may come in handy for crypto hedge funds.

Compulsory redemptions

Redemption can be forced upon investors without the need to give any reason i.e. you can kick out an Investor in your Fund without justification.

• Our Template M&A specifies that Compulsory Redemptions require not less than 5 Business Days notice to the Investor.
• The redemption payment may be reduced with amount which the directors may reasonably deduct in respect of the costs and expenses of the Fund incurred in connection with such redemption.

Redeemed Shares bought back by the Fund shall be cancelled (“burned” in crypto speak) or, within limitations, held as treasury shares. Shares which have been cancelled shall be available for reissue.

Finally, under the terms of the M&A, Directors are given wide powers to waive any notice period, redemption fee, minimum holding requirement or any other restriction or conditions applicable to the redemption of Shares by one or more Shareholders.

3. Valuing the Fund

As can be expected, the M&A has detailed provisions as to how the Net Asset Value of the Fund is to be determined.

The NAV after all is the key number to measure the Fund’s performance - and the Managers’ performance fees.

The basic arithmetic is simple: aggregate the value of all assets in the fund and deduct all its liabilities.

For Approved Funds, it is the Fund Administrator who will be put in charge of the determination of the NAV and hence the calculation of the Manager’s fees, typically with the assistance of proprietary software solutions.

For Incubator Funds who do not appoint a Fund Administrator, the NAV will not be verified by an outside party, however software packages are available that make the in-house determination easier.

With crypto hedge funds, it helps that digital assets are trading on an ongoing basis but Managers needs to carefully define the times of their data feeds (typically Close of Business on the Valuation Day in the BVI).

In this context, whilst perhaps tempting from an ideological point of view, denominating the NAV in a non-stablecoin digital asset will add a significant complexifier to the calculation of your Fund’s NAV. If Subscriptions are in fiat USD or USD stablecoin (see below), it is advisable to denominate the Fund’s Shares in USD or its digital equivalent.

Finally, Managers can amortize any expense or liability of the Fund over such period as they see fit. Such amortization typically includes the Fund’s setup costs (including Otonomos’ and legal fees) which, if non-amortized, would have to be taken out of the first NAV of the Fund and hence disproportionally impact early Investors.

4. The Fund’s Governance

The Fund’s governance relates to the rights of the Fund’s Shareholders and Directors in how the Company is managed.

Since the Fund is a Company, the reference governance framework is that of a delegation of power to the Company’s Directors by its Shareholders, however some significant deviations may apply:

• Directors can only be removed without cause if at least 75% of Shares entitled to vote pass a resolution to this effect.
• With cause, only a Director resolution can remove a Director.

Helpfully, none of the Shareholder or Director meetings have to be held in BVI and all can be held by electronic means.

B. Sign On The Dotted Line: The Subscription Agreement

Investors may ask for a copy of the Fund’s M&A however it is the Subscription Agreement (often referred to as the “Sub”) which is the face of the Fund with Investors.

As with the template Term Sheet in Part III, we have provided a full draft of the Subscription Agreement on an “as is” basis in the form of an annotated shared Google document.

Its Introduction is very clear that the Subscription Agreement is effectively taking over from a Private Placement Memorandum of a fully regulated fund as the key document by which you will offer Investors to subscribe for and purchase Shares in your Fund.

It hence urges Investors before completing the Subscription Agreement to read the Term Sheet relating to the offering of Shares in the Fund and the Subscription Agreement in full.

What follows the Instructions section is a significant document (typically around 50 pages for a BVI Incubator Fund) with plenty disclaimers aimed to provide legal protections for the Fund’s Managers in the first place.

In its legacy analog format, on the whole the Sub is often repetitive and contains a number of forms that require the same information for each form: A digital version of the Sub could be made a lot more streamlined and could even be done with altogether in an onchain version of a Fund setup (see Part V).

Per Motum Contrarium

The contrary to the Subscription Agreement is the (much shorter) Redemption Notice to be used when an Investor wants to come out of the Fund.

Key is the deadline for submission: the cut-off time is typically end of business day (5 p.m.) in the timezone where the Fund is located (BVI) on the day before the Redemption Day (as defined in the Fund’s M&A).

When redemption is monthly, the Redemption Day is typically the first business day following the Valuation Day.

The Valuation Day is either the last business day of the month or the first business day of the following month.

When redemption is quarterly it will be the last business day of the quarter or the first business day of the following quarter, as the case may be.

As noted earlier, the interests of Investor and Manager are diametrically opposite when it comes to redemptions: the Investor wants the highest level of liquidity, whilst Managers prefer “sticky money” and risk attracting loose-footed capital if they are too generous with redemption terms.

We generally see that its is difficult for Managers to get away with strict redemption terms in a crypto hedge fund, including quarterly redemptions, on the basis that Investors perceive crypto markets as more liquid than traditional asset classes and hence expect the same if not higher level of liquidity compared to tradfin hedge funds.

Can I accept crypto from Investors and send crypto back when they redeem?

BVI Funds must appoint a compliance person who will be reviewing the submitted forms and who will assist candidate Investors with filling out the Subscription Agreement.

For funds who do not appoint a fund administrator (which is not required for a BVI Incubator Fund), onboarding checks are left to the Fund, typically by one of the Fund’s Directors who doubles as its compliance person.

However at some point soon, Managers may want to farm out the onboarding of Investors to fund administrators.

Such fund admins will then also calculate the NAV for the fund rather than those calculations being done in-house, which should give comfort to Investors (see Part I).

A growing number of fund admins is getting familiar with crypto, however a major stumbling block when working with fund admins and other service providers is when the Fund seeks to accept crypto from Subscribers, mainly because of AML concerns.

The perception is that in contrast with fiat banking, a self-custodied crypto wallet is as such not linked to an identity and could be anybody's. In this view, there is no way of verifying that the crypto sent under a Subscription Agreement originates from the person or entity that signs the Agreement.

We believe such AML concerns can be alleviated in a number of ways:

• The blockchain way would be to accept proof of ownership of the wallet by letting its owner sign a transaction on blockchain that attests to his/her identity, however this is a bridge too far for many service providers.
• Alternatively, only custodied wallets could be used for Subscriptions and Redemptions, on the basis that centralized exchanges will have done DD on their clients when opening an account for them.
• If a fund admin is appointed, it can have systems in place that rely on service providers such as Chainalysis to establish the origin of the crypto used to Subscribe for Shares in the Fund.

Conclusion

A BVI Incubator and Approved Fund can pretty much raise on the basis of their finalized Terms Sheet and use the Subscription Agreement to drag Investors over the line.

However, the Subscription Agreement does make reference to the Fund’s Memorandum and Articles and acceptance of the terms of the Sub Agreement implies acceptance of the Fund’s M&A.

The Subscription Agreement is also the locus for client Due Diligence, with reams of forms, including self-certifications for both Individual and Entity Subscribers, and plenty more representations e.g. as to Subscribers’ tax status, political connectedness, etc.

The good news is that a Manager is entitled to rely on such certifications and representations, putting a lot of the onboarding burden on the shoulders of Subscriber.

The bad news is that a lot of the onboarding burden is on the shoulder of Subscriber!

As a result, raising money even in a reg-lite Fund still involves heavy analog processes which - if Otonomos had seven lives! - we would love to smartcontractify and fully put onchain.

In the last Part of this Fund Special, we have shared some ideas how.