In reaction to the growth and popularity of cryptocurrencies and digital tokens, the SEC has recently begun to exercise its authority over the digital asset market. The SEC, which is responsible for oversight of the securities markets in the United States, has determined that most cryptocurrencies and digital tokens are by definition “securities” and therefore subject to its jurisdiction under the federal securities laws. Consistent with that view, the SEC has made public statements, issued investor alerts and carried out enforcement actions addressing digital assets within the traditional legal framework for primary offerings and secondary market trading of securities.
Receiving less attention but no less significant are the activities of investment professionals who are advising others on investing in cryptocurrencies and digital tokens. Digital assets are becoming widely viewed as a distinct asset class which can offer investors additional alpha and diversification strategies, and investment professionals and private hedge funds are quickly becoming active institutional players in the market.
Investment advisers are regulated by the SEC under the Investment Advisers Act of 1940 (Advisers Act). The Advisers Act defines “investment adviser” as a person that for compensation engages in the business of providing advice to others or issuing reports and analyses regarding securities. Investment advice is construed very broadly and includes not just the activities of traditional money managers and financial advisors. Management of private investment funds, dissemination of market trend reports, asset allocation recommendations, selection of other advisers, and publication of buy-sell signals can represent the business of investment advisers.
Since cryptocurrencies and digital tokens are securities, persons providing advice to others about investing in digital assets are subject to SEC regulation under the Advisers Act. To date, there has been a paucity of public statements or enforcement efforts by the SEC regarding investment advisers in the digital assets space. But all those in the business of advising clients on digital assets must nonetheless be mindful of Adviser Act regulation. Matters requiring close attention under the Advisers Act include the safeguarding and custody of client assets, trading execution standards, appointment of a compliance officer and adoption of a compliance program, client privacy, cybersecurity, know-your-customer and anti-money laundering, and accounting for expenses, net asset values and investment returns. Persons who violate the Advisers Act can be subject to fines, sanctions and criminal penalties.
Set forth below is a summary of certain of the substantive provisions of the Advisers Act.
- SEC Registration. Investment advisers, including advisers to private funds, may be required, depending on assets under management, to register with the SEC by filing a Form ADV. Form ADV requires information about an investment adviser’s business, ownership, clients, employees, business practices, affiliations, and any disciplinary events of the adviser or its employees.
- Fiduciary Duty to Clients. Investment advisers have an affirmative obligation to deal fairly with clients and to act in their best interests. This standard includes the duty to provide full disclosure of all material facts to clients regarding an adviser’s disciplinary history, financial condition and actual or potential conflicts of interest with clients.
- Suitability of Advice. Investment advisers are required to provide advice to clients based on clients’ financial situation, investment experience and investment objectives. Advisers are also required to have a reasonable and independent basis for investment recommendations to clients.
- Trading. With respect to trading in securities, advisers must:
- Seek the best execution of clients’ securities transactions
- Avoid transacting directly with clients for the advisers’ own account without disclosure
- Not act as a broker in a client transaction when also acting on behalf of the counterparty
- Avoid cross trades between clients
- Allocate aggregated client orders fairly
- Advertising. Investment advisers are prohibited from using misleading or inaccurate advertising or communications on social media. In particular, advisers may not use testimonials or refer to past specific recommendations. Any advertisements that includes past performance also must not be misleading or imply future investment results.
- Custody of Client Assets. Investment advisers may not have possession or control of client assets or maintain client funds. Advisers are required to have a qualified custodian hold client assets. Qualified custodians include broker-dealers, banks, savings associations, futures commission merchants, and trust companies.
- Cybersecurity. Investment advisers are required to have systems and written policies and procedures in place which are designed to mitigate cybersecurity risks. Advisers must also test its systems, perform due diligence on technology service providers and conduct training for officers and employees.
- Use of Solicitors. An advisers cannot use third a party solicitor without a written agreement that sets forth solicitor’s obligations to deliver to prospective clients the adviser’s client brochure and a statement of the solicitor’s arrangement.
- Supervision and Compliance. Advisers have a duty to supervise their personnel and establish written internal compliance programs. Advisers must appoint a chief compliance officers to monitor and enforce compliance programs. A compliance program must include:
- Written policies and procedures designed to prevent fraud, theft and other violations of the Advisers Act
- A code of ethics covering an adviser’s duty to its clients with standards of conduct
- Practices to prevent misuse of insider information, including material, non-public information about the adviser’s securities recommendations.
- Firm Brochure. Advisers must prepare and deliver to clients a brochure containing information about the business practices, investment strategies, fees, conflicts of interest, and disciplinary history.
- SEC Filings. Advisers must complete and file with the SEC a Form ADV to register. Private fund advisers with at least $150 million in private fund assets under management must submit regular reports on Form PF covering fund size, leverage, investor types, investor concentration, liquidity and performance.
- Client Privacy Rules. Advisers must protect the privacy interests of clients and deliver to clients privacy policies. Advisers must also provide clients with an opportunity to opt-out or block advisers from sharing personal financial information with third parties.
- Advisory Contracts. Advisory agreements between an adviser and a client must set out the fees charged by the adviser and how fees are calculated. Performance fees are prohibited except for “qualified clients,” i.e., clients with at least $1,000,000 under management with the adviser or net worth of $2,000,000 and certain private funds. Contracts generally may not waive compliance with any provision of the Advisers Act, limit an adviser’s liability, provide indemnification of the adviser or charge the client termination fees.
- Recordkeeping. Each adviser is required to maintain detailed books and records about the adviser’s business and compliance with fiduciary obligations for no less than five years.
- SEC Examinations. All investment advisers are subject to periodic on-site examinations by the SEC. High risk activities are often a focus of SEC reviews.
- Anti-Money Laundering. Although not required under the Advisers Act, many advisers adopt anti-money laundering programs as a best practice or as part of OFAC economic and trade sanctions compliance.Some of the requirements of the Advisors Act are just beginning to be addressed by market participants. For example, custodians and fund administrators are testing the use of “cold” and “hard” digital wallets and “multi-signature” protocols to meet the custody requirements for client assets. Backup power and cybersecurity risk management systems specific to blockchain technology are in development to respond to potential hackers, EMP attacks, internal sabotage and natural disasters. Investment advisers have also begun to formulate and adopt internal policies and procedures specific to digital assets that cover such areas as conflicts of interest between and adviser and its clients, personal and proprietary trading of adviser personnel in relation to client transactions, digital asset valuations, fee calculation methodology and recordkeeping on the blockchain. It should be noted that, with limited exception, non-U.S. investment advisers providing investment advice to United States persons (including private funds with U.S. investors) about digital assets are subject to the Advisers Act. Certain advisers that are not permitted to register with the SEC, due to the amount of assets under management or other factors, are also subject to state securities laws that tend to mirror the federal scheme.