The SEC’s Division of Investment Management sought comment on the application of the Commission’s “Custody Rule” to cryptoassets. Pursuant to this rule – Rule 206(4)-2 under the Investment Advisers Act (click here to access) – investment advisers who have custody of client funds and securities must maintain certain procedural safeguards and hold such funds with a qualified custodian, which includes banks, broker-dealers and other enumerated entities. Among other things, the Division seeks input into challenges faced by IAs in complying with the Custody Rule for digital assets; to what extent, if at all, IAs consider cryptoassets funds or securities; to what extent are cryptoassets currently included in calculating regulatory assets under management; and how can distributed ledger technology be used for evidencing ownership of securities. 

The Division solicited comment through a letter to the Investment Adviser Association. In the letter, the Division also asked for  views on non-delivery versus payment transactions by investment advisers.

Because custody includes both the authority to access clients’ securities and funds in addition to physical possession, the SEC has expressly recognized a limited exception to the Custody Rule – the “authorized trading exception” – that permits an investment adviser to issue instructions to a qualified custodian to effect or settle trades solely on a delivery versus payment basis. (Click here to access fn. 10 to the SEC’s 2003 release adopting final rules for the custody of funds or securities of clients by investment advisers.) This means that, under the SEC’s explicit approval, investment advisers may only trade or transfer funds or securities out of a client’s account when there is a “corresponding transfer of securities or funds into the account.” However, when authorizing this DVP exception, the SEC was silent on non-DVP transactions. The Division now desires to understand what instruments trade on a non-DVP basis; what risks of fraud or loss may be associated with non-DVP trading and how they are controlled; what role custodians play in non-DVP trading; and how evolving technologies, such as distributed ledger technology, may contribute to enhanced or diminished customer protection for non-DVP trading, among other questions. (Click here for access to the 2013 Division release on Inadvertent Custody that also discusses the authorized trader exception in fn 1.)

Separately, the Canadian Securities Administrators and the Investment Industry Regulatory Organization of Canada solicited input on how regulatory requirements pertaining to securities or derivatives exchanges could be “tailored” for cryptoasset trading platforms located in Canada or that have Canadian participants. Among other things the CSA and IIROC are trying to better understand for cryptoasset trading platforms: custody and verification, price determination, surveillance of trading activities, systems and business continuity planning, conflict of interest issues, and insurance. The Canadian regulators will accept comments through May 15, 2019.

Finally, the SEC will host a forum to address distributed ledger technology and related issues including initial coin offerings and cryptoasset platforms, on May 31 at the SEC’s headquarters in Washington, DC. The event will also be webcast on the SEC’s website.

In other legal and regulatory developments involving cryptoassets:

  • SEC Chairman Concurs With Division Head That a Cryptoasset’s Regulatory Classification May Morph Over Time: Jay Clayton, Chairman of the Securities and Exchange Commission, formally concurred with the June 2018 views of William Hinman, the SEC’s Director of Corporation Finance, that the nature of a cryptoasset is not static and that, depending on how it is promoted and likely used, a cryptoasset, may change over time. According to Mr. Clayton, “[a] digital asset may be offered and sold initially as a security because it meets the definition of an investment contract but that designation may change over time if the digital asset later is offered and sold in such a way that it will no longer meet that definition.” Mr. Clayton expressed his views in a March 7, 2019 letter to Congressman Ted Budd (R-NC). In a speech delivered in June 2018, Mr. Hinman indicated that the cryptoasset ether was likely a security when issued but is not a security today. (Click here for further background in the article “Anything But Sleep Inducing: SEC Corporate Finance Director Says Ether Not a Security and Canada Issues Guidance on Utility Tokens” in the June 17, 2018 edition of Bridging the Week.)  
  • CFTC Settles Charges With Non-US Trading Platform and Its CEO for Allegedly Engaging in Margined Bitcoin Transactions With Retail Clients Contrary to Law: The Commodity Futures Trading Commission settled an enforcement action filed during September 2018 against 1pool Ltd and Patrick Brunner, its chief executive officer and principal, for acting as a futures commission merchant without registration; entering into leveraged commodity transactions with retail persons that were not executed on a licensed exchange; and failure to supervise. 1pool operated an online trading platform that offered contracts for differences on a margined-basis referencing gold, West Texas Intermediate crude oil and other commodities; it accepted bitcoin as margin so that clients could effectively control a large notional value of the relevant commodity. To resolve this matter, the defendants agreed to pay a fine of US $175,000, disgorge US $246,000 of profits and repay 93 bitcoin (approximately US $570,000) to its US customers. The SEC also filed an enforcement against the defendants. (Click here for further information in the article “CFTC and SEC Charge Non-US Company With Illegally Engaging in Off-Exchange Margined Transactions With Retail Customers While Accepting Bitcoin as Payment” in the September 30, 2018 edition of Bridging the Week.)  
  • Global Bank Standard Setter Issues Guidance for Banks Obtaining Cryptocurrency Exposure: The Bank of International Settlements cautioned banks acquiring cryptoasset exposure to conduct “comprehensive analysis” to adequately assess risks stemming from such exposure. BIS also advised such banks to maintain a “clear and robust risk management framework” that is “appropriate” to the risk of cryptoasset exposure; identify material exposure as part of its regular financial disclosures; and inform their supervisory authority of actual and planned cryptoasset activity. BIS advised that a bank’s risk management framework for cryptoasset activity should be made part of the bank’s overall risk management processes, including processes related to ordinary anti-money laundering and related activities.  
  • Clearing and Settlement Institution Recommends Guiding Principles for Processing of Digital Securities: The Depository Trust and Clearing Corporation issued a white paper recommending guiding principles for the post-trade processing of cryptosecurities. Drawing on Principles for financial market infrastructures developed by international standards setting bodies (click here to access), DTCC argued that any platform for post-trade processing of security tokens should satisfy certain requirements: (1) it should be clear which law or legal basis applies to all activities and user relationships; (2) there should be “appropriate governance relationships” to support its operation, including functionality and risk management; (3) the platform should have a “sound framework” for managing legal, credit, liquidity, operational and other risks; (4) there must be systems and procedures to ensure settlement finality; (5) the platform must ensure the integrity of cryptosecurities, as well as minimize and manage safekeeping and transfer risks; (5) be resilient; and (6) ensure robust recordkeeping. According to DTCC, these characteristics should be dealt with in appropriate rules and regulations of relevant cryptosecurity post-trade-processing platforms.  
  • Colorado Authorizers Issuer Registration Exemption for Certain ICOs: Colorado enacted a new law – the Colorado Digital Token Act – that exempts from securities registration cryptoassets designed for consumptive purposes and not marketed for speculative or investment purposes. Under the law the consumptive purposes of eligible cryptoassets – termed “digital tokens” – must be available at the time of sale or within 180 days. The law also exempts persons who broker digital tokens and from broker-dealer and salesperson licensing requirements. Filing a notice of intent to take advantage of these exemptions and other requirements will apply. The law is expected to go into effect later in 2019.

My View: Mr. Hinman’s June 2018 analysis of digital tokens and recognition that the characteristics of a digital token (such as ether) may change over time – likely resulting in a different legal categorization – now appears to be formally embraced by Mr. Clayton. However, Mr. Clayton still seems to take a very broad view of when an initial offering of cryptoassets constitutes an investment contract, thus qualifying the digital tokens as securities. Although saying each scenario presents unique facts and circumstances (relying on the landmark Supreme Court decision, SEC v. W.J. Howey and its progeny), Mr. Clayton suggests that almost all investments in common ventures “premised on a reasonable expectation of profits to be derived from the entrepreneurial or managerial efforts of others” render the underlying cryptoasset a security – whether the profits are achieved directly from a venture (e.g., through profits) or market appreciation. (Click here to access the Howey decision. Click here for insight into Mr. Clayton’s views on the potential morphing characteristic of cryptoassets and the application of Howey to cryptoassets in an interview on November 27, 2018, with Glenn Hutchins, a co-founder of Silver Lake Partners).

However, at the fringes, it still is unclear when market appreciation might be considered derived from a promoter’s hype as opposed to investor sentiment. A recent settlement by the SEC suggested that if a promoter takes too many steps to list a cryptoasset initially sold to raise funding for a project on an exchange for trading – even if the token was designed solely to be used in connection with the project – the digital token will likely be viewed as a security by the Commission. (Click here for background in the article “ICO Promoter Settles SEC Enforcement Action for No Fine After Self-Reporting Potential Securities Law Violations” in the February 24, 2019 edition of Bridging the Week.)

As a result, it appears to me that, applying the SEC’s broad view of Howey, smart kids who purchased and held, as collectibles, Beanie Babies from Ty Inc. years ago and later eagerly resold them on eBay for a profit, potentially could be regarded to have been transacting in securities depending on the amount of advertising and other promotional activities by Ty. Such an outcome makes no sense. There needs to be formal SEC clarification – perhaps creating a safe harbor along the lines of Colorado’s new Digital Token Act.