Recognizing the “swiftly developing” digital asset marketplace—a loosely defined sector encompassing cryptocurrencies, virtual coins or tokens (including Initial Coin Offerings or “ICOs”), and other blockchain-related financial assets—the SEC’s Division of Investment Management (the “Division”) has commenced an open-ended request for public comment on how such crypto-assets impact its decades-old Advisers Act Custody Rule (Advisers Act Rule 206(4)-2). The Division’s request for comment comes in the form of a March 12, 2019 letter to the Investment Adviser Association (“IAA”), a lobbying/trade group representing the investment advisory industry.
By way of background, the Custody Rule sets up a number of requirements for SEC-registered investment advisers that have “custody” of a client’s funds or securities. Custody is defined as “holding, directly or indirectly, client funds or securities, or having any authority to obtain possession of them.” Notably, custody includes, among other things, any arrangement under which the adviser is authorized to withdraw client funds or securities, as well as acting as general partner, or in a comparable control position, for an investment fund. The four primary obligations of an adviser having custody are that the adviser must: (i) maintain those funds or securities with a “qualified custodian;” (ii) notify the client in writing of the qualified custodian’s name, address, and the manner in which the funds or securities are maintained; (iii) have a “reasonable basis” for believing that the qualified custodian sends an account statement, at least quarterly, to each client, identifying the amount of funds/securities and setting forth all transactions in the account; and (iv) arrange for an independent public accountant to conduct an annual surprise examination in order to verify the safekeeping of the client’s funds and/or securities. The Custody Rule provides a number of exemptions to some of the above requirements; most notably, one that allows investment fund advisers to avoid the surprise exam requirement so long as audited financial statements are distributed within 120 days of the end of the fund’s fiscal year.
In an effort to “further inform our consideration of how characteristics of digital assets impact the application of the Custody Rule,” the Division’s request for comment seeks public comment on a wide array of trenchant queries, including the following:
- To what extent are investment advisers construing digital assets as “funds,” “securities,” or neither, for purposes of the Custody Rule?
- To what extent do investment advisers construe digital assets as “securities” for purposes of determining whether they meet the definition of an “investment adviser” under the Advisers Act?
- To what extent are investment advisers including digital assets in calculating regulatory assets under management for purposes of meeting the thresholds for registering with the Commission?
We find these inquiries especially intriguing in light of recent SEC enforcement actions against a number of ICO promoters, and ongoing jawboning on this topic by SEC leadership, largely to the effect that the Commission is looking at many of these instruments as presumptively being “securities.” However, the premise of these queries is that various digital assets can be securities, funds or neither. While this particular topic is beyond the scope of this note, we will watch with interest as the comments come in.
Additionally, in light of the well-documented acts of misbehavior in the cryptocurrency space—for example, the Mt. Gox incident, where theft, fraud, and mismanagement resulted in the loss of hundreds of million dollars worth of Bitcoin—the Division proffered the following inquiries:
- How should concerns about misappropriation of digital assets be addressed and what are the most effective ways in which technology can be leveraged to address such concerns? How can client losses due to misappropriation of digital assets most effectively be remedied?
- To what extent do investment advisers use state chartered trust companies or foreign financial institutions to custody digital assets? Have these investment advisers experienced similarities/differences in custodial practices of such trust companies as compared to those of banks/broker-dealers?
Interestingly though, the Division also appears to express a level of confidence and promise in these new technologies, which it also refers to as “DLT” or distributed ledger technology, posing the following question:
- To what extent can DLT be used more broadly for purposes of evidencing ownership of securities? Can DLT be useful for custody and recordkeeping purposes for other types of assets, and not just digital asset securities? What, if any, concerns are there about the use of DLT with respect to custody and recordkeeping?
Interested parties are invited to comment on these issues as well as the broader question of “what considerations specific to the custody of digital assets should the staff evaluate when considering any amendments to the Custody Rule?” (emphasis added). All comments will be published unredacted on the SEC’s web site as received.
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