In the span of the last five months, the Securities and Exchange Commission (SEC) and its staff have issued two statements, a risk alert and an exam priorities roadmap, all of which address digital assets in full or in part. For those who are already active in this space, this regulatory focus should serve as a bit of light in-the-tunnel, directing the activities of participants who wish to avoid a disciplinary action. For those not yet advising clients on digital assets or participating in their distribution, recent SEC guidance should be kept close at hand and form the foundation for entrance into this market.
The recent peak in SEC guidance began in November 2020, when the SEC’s Division of Investment Management (IM), in consultation with staff in the SEC’s Strategic Hub for Innovation and Financial Technology (FinHub), issued a statement encouraging interested parties to speak directly with SEC staff on the application of Rule 206(4)-2 (the Custody Rule) under the Investment Advisers Act of 1940, as amended (the Advisers Act), to digital assets.1 This statement, issued in response to the Wyoming Division of Banking’s views with respect to the definitions of “bank” and “qualified custodian” under the Custody Rule, made clear that SEC staff intends to reserve for federal-level interpretation how the requirements of the Custody Rule should be applied to digital assets for which SEC-registered investment advisers and their custodians are responsible.
Custody issues continued to be in the spotlight in December 2020 when the SEC laid out its vision for how broker-dealers can comply with the custody requirements of Rule 15c3-3 (the Customer Protection Rule) under the Securities Exchange Act of 1934, as amended, for investments in digital asset securities.2
Having T-d up custody issues,3 other issues are now getting further attention. These issues are broad in scope and depend to some degree on the registration status of the legal entity involved in distributing the digital assets. To get a handle on the issues and the SEC’s approach, SEC-registered investment advisers, broker-dealers, electronic trading platforms and transfer agents should follow the roadmap set out by the SEC’s Division of Examinations (formerly, the Office of Compliance Inspections and Examinations) in March 2021, in a new Risk Alert.4 Market participants also should review what SEC staff has to say about digital assets in the Division of Examinations’ 2021 Examination Priorities publication.5
Division of Examinations’ risk alert
The Risk Alert, issued February 26, 2021, is based upon the Division of Examinations’ staff findings from its examinations of broker-dealers, investment advisers and transfer agents involved in some aspect of the offer, sale and trading of digital assets. It encourages market participants to utilize its findings and observations when developing and enhancing compliance practices, and as an outline for future examinations relating to digital assets.
Importantly, the staff notes two reasons for its focus on digital assets: first, it believes digital assets that are securities involve unique risks, and second, it believes distributed ledger technologies involve distinct features that must be considered before developing compliance policies and procedures that are consistent with federal securities laws. The staff notes that its use of the term “digital asset” is intended to refer to an asset that is issued and/or transferred using distributed ledger or blockchain technology, including, but not limited to, “virtual currencies,” “coins” and “tokens.” In doing so, the staff reiterates that a particular digital asset may or may not meet the definition of “security” under the federal securities laws.6
The discussion below, like the Risk Alert, is divided into four parts, focusing on SEC advice specific to investment advisers, broker-dealers, national securities exchanges and transfer agents.
The Risk Alert cautions investment advisers to focus on portfolio management, books and records, custody, disclosures, pricing and registration:
Portfolio management. The staff encourages investment advisers to focus on regulatory compliance associated with portfolio management. In particular, the staff points to the proper classification of digital assets, including whether a digital asset meets the definition of “security” under the federal securities laws. In addition, the staff notes that investment advisers should focus on their due diligence of digital assets, including but not limited to whether the adviser understands the digital asset, digital wallets, or any other devices or software used to interact with the digital asset network or application. For example, investment advisers should ensure that their diligence covers liquidity and volatility of the digital asset. The staff also emphasizes that advisers should focus on risks related to trading venues, trade execution and settlement facilities. Investment advisers should evaluate and mitigate these trade-related risks, including but not limited to risks in connection with security breaches, fraud, insolvency, market manipulation, the quality of market surveillance, Know Your Customer rules and AML procedures. Investment advisers should also anticipate managing risks and complexities related to “forked” and “airdropped” digital assets, and the issues that arise as a result of such events. This may include addressing the allocation of digital assets across client accounts and conflicts of interest, among other things. Last but not least, the staff recommends that investment advisers consider whether their fiduciary obligations have been met with respect to investment advice on digital assets.
Books and records. The Risk Alert acknowledges the complicated nature of digital asset trading platforms. Therefore, the staff encourages investment advisers to consider the reliability and consistency of digital asset trading platforms, especially with respect to order execution, settlement methods, and post-trade recordation and notification. As advisers design recordkeeping policies, they will want to consider how to account for these complexities.
Custody. The Division of Investment Management has indicated that it is preparing amendments to the Custody Rule,7 and that it has an “open door” policy when it comes to questions regarding the application of the Custody Rule to digital assets. Persons considering speaking with the staff should familiarize themselves with the issues that the Risk Alert identifies as requiring the attention of investment advisers, regardless of whether the Custody Rule is applicable. For example, the staff signals its intention to focus on incidences of unauthorized transactions in digital assets, such as theft of digital assets. In addition, the staff plans to focus on controls related to safekeeping digital assets, including those governing employee access to private keys and trading platform accounts. The staff also encourages investment advisers to ensure that their business continuity plans address situations where key personnel have exclusive access to private keys. Investment advisers will also want to consider how they might evaluate the harm that results from the loss of a private key, as well as the reliability of software that is used to interact withdigital asset networks. For those digital assets that are stored on digital asset trading platforms or with third-party custodians, investment advisers will want to consider whether and how these platforms and custodians provide safekeeping for client funds and digital assets. Last, the staff will focus on, and investment advisers should be prepared to be examined on, security procedures in connection with digital wallet software and hardware.
Disclosures. The Risk Alert acknowledges that investment advisers may provide disclosures to their clients through a variety of media and publications. Regardless of the medium, the staff indicates in the Risk Alert that it expects investment advisers to disclose the unique risks associated with digital assets and to focus on the circumstances in which those risks may be heightened. The staff notes that it will focus examinations on disclosure of conflicts of interest and related party transactions. In addition, the staff will focus on whether the investment adviser has disclosed the complexities and underlying technology of the digital asset. The staff will also focus on disclosures related to technical, legal, market and operational risks associated with digital assets, including but not limited to cybersecurity and custody risks. Last, the SEC will focus on disclosures regarding price volatility, illiquidity and valuation methodologies in connection with digital assets.
Pricing. The Risk Alert also acknowledges that digital assets may present valuation challenges for investment advisers as a result of market fragmentation, illiquidity, volatility and the potential for manipulation. Because of these challenges and the fact that evaluation methodologies differ among advisers, the staff expects that advisers will apply a variety of pricing methods when managing digital assets on behalf of clients. Therefore, the staff will focus on investment advisers’ valuation methodologies, including methodologies disclosed and utilized by advisers to determine principal markets for and fair value of digital assets. The staff will also focus on how investment advisers value digital assets following significant events, and whether and how advisers recognize “forked” and “airdropped” digital assets. The staff will also review disclosures related to advisory fee calculations, and the impact that valuation has on advisory fees.
Registration. Last, the staff intends to focus on registration issues, including but not limited to an investment adviser’s calculation of regulatory assets under management, the characterization of digital assets in pooled vehicles managed by the adviser and the status of advisory clients. In addition, the staff notes that it will focus on whether private funds managed by investment advisers are properly relying on registration exemptions. To this point, the staff references an SEC enforcement action against a hedge fund manager for an investment company registration violation, where the fund was invested in digital assets.
Broker-dealers are encouraged to focus on registration, safekeeping of funds, AML, offerings, disclosure of conflicts of interest and outside business activities:
Registration requirements. The staff states that it will focus not only on the registration status of broker-dealers distributing digital assets, but also on the registration status of a broker-dealer’s affiliates, raising the possibility that an affiliate will be deemed to be acting as an unregistered broker-dealer, depending on its involvement in the distribution of digital assets that are securities.
Safekeeping of funds and operations. The staff expects broker-dealers to ensure the safekeeping and custody of customer funds and digital assets that are securities in compliance with federal securities laws. To this end, the staff plans to focus its examinations on broker-dealer operations, including those that are specific to the safety and custody of digital assets that are securities.
Anti-Money Laundering (AML). The staff observed during examinations that broker-dealers are facing challenges when implementing AML compliance programs due to the unique characteristics associated with distributed ledger technology and blockchain technology. The staff noted several AML program deficiencies, including issues related to AML procedures, controls and documentation regarding digital assets that are securities. As a result, the staff will evaluate broker-dealers’ AML compliance programs in connection with digital assets.
Offerings. The staff will also focus examinations on a review of broker-dealers’ due diligence and disclosures made to customers in connection with underwriting and private placement activity for digital assets that are securities.
Disclosure of conflicts of interest. The staff plans to examine broker-dealers’ conflicts of interest, as well as the disclosure of such conflicts, when broker-dealers provide services in more than one capacity. For example, the staff noted that broker-dealers may operate as trading platforms or proprietary traders for digital assets that are securities, either on their own platform or other platforms. In addition, the staff will focus on broker-dealers’ written supervisory procedures that are intended to address conflicts of interest in connection with digital assets.
Outside business activities. During its examinations of broker-dealers, the staff noted that financial professionals were engaging in outside business activities related to digital assets. As a result, the staff plans to focus on broker-dealer policies and procedures in connection with outside business activities related to digital assets, including a broker-dealer’s process for determining whether the activity qualifies as a private securities transaction under applicable FINRA rules and has been approved and supervised on that basis.
National securities exchanges
The staff will examine electronic trading platforms that provide a mechanism for trading digital assets, to determine if such platforms are required to be registered as national securities exchanges under US law, or may lawfully operate pursuant to an exemption from registration. In the case of a platform operating as an Alternative Trading System (ATS), the staff will examine for compliance with ATS rules.
The staff recognizes that issuers are using distributed ledger technology to perform various administrative functions for shareholders, including recordation of ownership. Although transfer agents may be new to the use of distributed ledger technology, the federal securities laws applicable to registered transfer agents are well-established. Therefore, the staff intends to focus examinations on whether registered transfer agents who provide administrative functions for digital assets that are securities are complying with the federal securities laws with respect to this asset class.
Division of Examinations’ 2021 priorities
Those interested in the digital asset space should also refer to the SEC’s Division of Examinations’ 2021 priorities guidance. With respect to retail investor sales practices, the staff notes that it will prioritize sales practice examinations for various product types, including but not limited to digital assets. In this context, the asset class consisting of digital assets is being viewed in the same light as exchange-traded products, real estate investment trusts, private placements, annuities and microcap securities, indicating that the staff considers digital assets to be “complex” products.
In addition, in a section discussing financial technology and innovation, the staff states that market participants who are engaged with digital assets should anticipate being examined on six topics, which primarily relate to the areas of focus identified in the Risk Alert. Broker-dealers and investment advisers should expect examinations to focus on (i) whether digital asset investments are in the best interests of investors, (ii) portfolio management and trading practices, (iii) the safety of client funds and assets, (iv) pricing and valuation, (v) the effectiveness of compliance programs and controls, and (vi) supervision of representatives’ outside business activities.
All SEC divisions are now actively engaged on the issues surrounding the issuance and distribution of digital asset securities and the ways in which retail investors may face special risks through an investment in this asset class. The Divisions of Examinations and Investment Management are both encouraging and inviting market participants to engage with them on issues related to digital assets. For the Division of Examinations, market participants are encouraged to engage on examination-related issues through the SEC’s FinHub. For the Division of Investment Management, market participants are invited to engage directly via email on issues related to custody of digital assets, and/or market participants can submit comments to the SEC in response to its request for comments on issues arising for broker-dealers with respect to digital asset securities.8 While promoting engagement and providing guidance, the SEC and its staff are essentially providing notice to market participants in the digital asset space that they should be prepared for SEC examinations; it will not be sufficient to say that there was no guidance. And, for market participants interested in, but not currently involved in, the offer, sale or trading of digital assets, the SEC and its staff have provided a roadmap of topics that should be considered and addressed prior to commencing business in the digital asset space.
1. SEC, Staff Statement on WY Division of Banking’s “NAL on Custody of Digital Assets and Qualified Custodian Status” (Nov. 9, 2020), https://www.sec.gov/news/public-statement/statement-im-finhub-wyoming-nal-custody-digital-assets.
2. SEC, Statement and Request for Comment, Custody of Digital Asset Securities by Special Purpose Broker-Dealers (Dec. 23, 2020), https://www.sec.gov/rules/policy/2020/34-90788.pdf.
3.For a discussion of custody issues, see https://us.eversheds-sutherland.com/NewsCommentary/Legal-Alerts/238535/Digital-asset-securities-broker-dealer-custody-issues.
4.SEC, Div. of Examinations, Division of Examinations’ Continued Focus on Digital Asset Securities (Feb. 26, 2021), https://www.sec.gov/files/digital-assets-risk-alert.pdf.
5. SEC, Div. of Examinations, 2021 Examination Priorities (Mar. 3, 2021), https://www.sec.gov/files/2021-exam-priorities.pdf.
6. See, e.g., SEC, Exchange Act Release No. 81207, Report of Investigation Pursuant to Section 21(a) of the Securities Exchange Act of 1934: The DAO (July 25, 2017), https://www.sec.gov/litigation/investreport/34-81207.pdf.
7.See Securities and Exchange Commission Regulatory Flexibility Agenda, https://www.reginfo.gov/public/do/eAgendaViewRule?pubId=202004&RIN=3235-AM32.
8.See Statement and Request for Comment, supra note 2.