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SEC and FINRA Raise Crypto Custody Concerns

 In a joint statement, staffs of the SEC’s Division of Trading and Markets and FINRA’s Office of General Counsel, raised significant regulatory concerns for broker-dealer firms deemed to have custody of digital assets.  The joint statement questions how a broker-dealer could comply with the customer protection rule (15c3-3), especially the obligation to safeguard customer assets.  The regulators, noting that $1.7 Billion worth of digital assets were stolen in 2018, express concern about how to adequately guard against fraud and theft.  They also ask how to reverse transactions made in error and how to properly control digital assets.  The SEC and FINRA staffs are also concerned about SIPA protection for the firm and its clients.  The next step is continued dialog with the industry: “The Staffs encourage and support innovation and look forward to continuing our dialogue as market participants work toward developing methodologies for establishing possession or control over customers’ digital asset securities.”

Now, what?  Will the SEC, in conjunction with the industry, offer some solutions to these difficult questions?  Or, will the regulator continue to push the crypto-industry to the Wild West corners of the securities markets including offshore jurisdictions and private networks?

SEC Alerts RIAs/BDs to Cloud Provider Monitoring Obligations

The SEC’s Office of Compliance Inspections and Examinations (OCIE) has issued a Risk Alert warning firms to monitor and supervise third-party cloud providers that house their regulatory data. OCIE has observed many firms failing to properly configure security settings and thereby neglect to utilize available security services such as encryption and password protection. OCIE has also seen weak oversight of third-party cloud providers including failures to assess information security and utilization of available security features. OCIE would like to see significant policies and procedures addressing the installation, maintenance and review of network storage solutions as well as robust vendor management policies that require the regular implementation of software patches and hardware updates.

Firms can (and probably should) outsource their network and data storage to qualified vendors, but they cannot abdicate their responsibilities to ensure the data is protected from unauthorized intrusion. The compli-pros must work with the IT folks to assess the cloud provider’s ongoing compliance.

SEC Says that ICO is Not a Securities Offering


The staff of the SEC’s Division of Corporation Finance has issued no-action relief that allows an initial coin offering without registration.  The no-action relief relies on an opinion of counsel that the underlying digital tokens are not securities as well as several other conditions including (i) the sponsor will not further develop the platform, (ii) the tokens will be immediately useable and functional, and (iii) the tokens are not marketed in a manner that emphasizes their potential for increased market value.  In a companion release, the SEC Strategic Hub for Innovation and Financial Technology (FinHub) issued guidance about how to determine if an ICO is an offering of securities under the applicable Howey test.  FinHub relies heavily on whether the sponsor of the network will engage in further development of the network or digital asset so as to generate increased market value for investors. 

Up until now, the SEC has taken the position that ICOs are securities offerings, subject to the Securities Act’s registration and disclosure requirements.  This no-action letter and companion guidance suggest that the SEC may back off its aggressive position and allow the digital token world to evolve organically.  What is unclear is whether any ICO sponsor should go forward without a no-action letter.

Federal Court Rules that the SEC Must Prove that Digital Tokens are Securities

A federal judge has ruled that an initial coin offering may not constitute an offering of securities.  In rejecting the SEC’s request for a preliminary injunction against an ICO, Judge Gonzalo Curiel of the Southern District of California, opined that the SEC failed to present sufficient facts to satisfy the Howey test requiring an investment of money in a common enterprise with an expectation of profit produced by the efforts of others.  Faced with conflicting interpretations of how the ICO operated, the Court denied the preliminary injunction because of genuine disputes about material facts.

The significance of this decision is that a court is requiring the SEC to factually prove the three prongs of the Howey test rather than simply accept the SEC’s position that digital tokens are securities.  If the SEC fails to prove its case and digital tokens are not securities, the SEC will not have the legal authority to regulate ICOs. 

SEC Fines Two Initial Coin Offerings

The SEC ordered two initial coin offerings to offer investors rescission and pay a $250,000 fine for failing to register the offerings under the securities laws. These cases represent the first time that the SEC has imposed civil penalties solely for ICO securities offering registration violations.  One of the respondents raised $15 million by selling digital tokens intended to create a new digital coin ecosystem related to advertising and mobile phones.  The other respondent raised $12 Million to create a blockchain technology for the emerging cannabis industry.    The SEC maintains that the digital tokens are “securities” under the Howey test and, therefore, the offerings violated the registration requirements of the 1933 and 1934 Acts.  Both respondents undertook to register the offerings.

Given the SEC’s concerns about disclosure and compliance for ICOs, it will be interesting to see the extent of disclosure required in the promised registration statements. 

SEC Says that Digital Tokens are Securities; Requires Trading Platform to Register as Exchange

The SEC fined and censured the founder of a digital token trading platform that failed to register as a national securities exchange.  The SEC argued that, under SEC v. Howey, the tokens traded included securities because the purchasers of tokens “invested money with a reasonable expectation of profits, including through the increased value of their investments in secondary trading, based on the managerial efforts of others.”  The token exchange allowed buyers and sellers to view pairs available for trading and a display of the top 500 bids and allowed users to enter buy and sell orders.

We expect a well-funded party will ultimately challenge the SEC in the courts about whether digital tokens are securities subject to SEC supervision.  However, until a court decides otherwise, those that trade in digital tokens and those that facilitate trading must register as broker-dealers or as exchanges. 

SEC Halts Trading in Company Touting Crypto Offering

 The SEC suspended trading of a public company that issued press releases claiming SEC approval of its cryptocurrency products.  The company’s press releases advertised that it had partnered with an SEC qualified custodian for cryptocurrency transactions and that it was conducting an SEC-registered token offering.  The SEC’s Cyber Unit Chief warned that the SEC “does not endorse or qualify custodians for cryptocurrency.”

Back in January, the SEC raised several regulatory questions around ICO offerings and notified the industry that it would not approve crypto-offerings until the issues were adequately addressed.  Any efforts to suggest otherwise will draw the attention of the Enforcement Division’s Crypto Unit.

SEC Halts Crypto Hedge Fund Offering for Failing to Register

 

The manager of a crypto hedge fund offered its investors rescission and agreed to pay a $200,000 fine for failing to comply with the securities.  The SEC argues that the fund, which invested in digital assets, was “engaged in the business of investing, holding, and trading certain digital assets that were investment securities.”  Consequently, the offering, which did not comply with Regulation D’s private offering safe harbors, should have been registered under the Investment Company Act.  The SEC charges violations of the registration provisions of the Securities Act and the Investment Company Act as well as the antifraud rules.  This case is the SEC’s first enforcement action against a crypto hedge fund manager for failing to register under the Investment Company Act.

OUR TAKE:  Most significant is the SEC Enforcement Division taking the position that a fund that invests in digital assets is subject to the securities laws.  It remains to be seen whether others will challenge that position in the courts.

 

CCS’s Garcia Reports on Futures Industry Association Conference 

Bridget Garcia of Cipperman Compliance Services recently attended the Futures Industry Association Law and Compliance Conference in Washington.  The well-attended event addressed cryptocurrencies and related regulation, a major issue of interest to the industry.  Panels discussed the evolution and purpose of cryptocurrencies and how the CFTC, SEC and FINRA will carve up regulatory responsibilities.  Moving onto more tactical matters, one panel discussed regulatory hot topics, including AML and GDPR, and another panel tackled CCO responsibilities.  Day 3 focused heavily on swaps and derivatives.  Feel free to contact Bridget if you want more information.

Link to conference summary