Source: https://www.globallegalinsights.com/practice-areas/blockchain-laws-and-regulations/06-the-custody-of-digital-assets-2020
Timestamp: 2020-07-11 10:15:10
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Blockchain Laws and Regulations | 06 The custody of digital assets - 2020 | GLI
Home Practice areas Blockchain & Cryptocurrency Regulation 2020 06 The custody of digital assets - 2020
Blockchain & Cryptocurrency Regulation 2020 | 06 The custody of digital assets - 2020
On the surface, the answer is simple: individuals can store their cryptocurrencies through a third-party custodian or intermediary, or, alternatively, directly in a “digital wallet” by controlling a “private key.” Private funds managed by registered investment advisers can store their cryptocurrencies with “qualified custodians.” Registered investment companies can store their cryptocurrencies only with custodians that meet additional requirements.1
But, alas, as is often the case with digital assets, a practical solution is not so simple. In reality, the operational and regulatory issues are more complicated, including whether the custody arrangements meet regulatory requirements, and whether they provide adequate safeguards, regardless of regulatory requirements.2
This chapter examines the custody requirements that apply to various industry players under U.S. Investment Advisers Act of 1940, as amended (the “Advisers Act”)3 and the Investment Company Act of 1940, as amended (the “1940 Act”),4 and analyses the challenges that they and the regulators face in evaluating arrangements for safeguarding digital assets.5
For the purposes of this chapter, “cryptocurrencies” refer to digital assets that function as a digital representation of a store of value, such as Bitcoin or Ethereum or similar assets. Cryptocurrencies are not issued or backed by a central government, and thus are not legal tender. Alternatively, we refer to cryptocurrencies as “digital currency” or “virtual currency.”
“Utility tokens” refer to coins or tokens that serve a particular (non-incidental) function, or give the holder rights or access to goods, licenses or services. A common form of utility token may give the holder the right to use a computer program that provides a kind of service for a defined period of time. Some refer to utility tokens as “app coins,” “app tokens,” or “utility coins.” Some utility tokens may be securities, others are not. As we will see later, whether or not a utility token is characterized as a security becomes critical in evaluating what custody rules apply.
“Security tokens” or “investment tokens” are tokens or coins that are securities for purposes of the federal securities laws. The status of a token as a securities token may be intentional or unintentional. Some utility tokens may start out as securities and at some point morph into non-securities, depending on their usage, how they are sold, and the expectations of the holders of those tokens.
Simply labelling a digital asset as a utility token, however, does not mean that the digital asset is not a security.6 The analysis of whether or not a utility token functions as a security token, or when a security token transforms into a utility token is beyond the scope of this chapter, but, again, the distinction is relevant for purposes of the custody analysis.
Current U.S. federal securities laws impose strict requirements on investment companies and investment advisers to safe-keep their assets and those of their clients. These laws are designed not just to ensure that assets are held securely, but also to enable auditors to verify that the assets exist. Why can’t the SEC apply these laws to safekeeping of cryptocurrencies, digital tokens and other digital assets? The simple answer is that these existing laws and regulations do apply to digital assets (maybe, and at least in theory). The real mystery to be solved is precisely how they apply.
The safeguarding of client assets has long been a priority of Congress and the Securities and Exchange Commission (the SEC). The legislative history of the 1940 Act, and, by implication, its companion statute, the Advisers Act, shows that Congress was clearly concerned with the potential for abuses or misappropriation of client assets held in investment trusts and investment companies that are managed by investment advisers:7
That investors in investment trusts and investment companies are subject to substantial losses at the hands of unscrupulous persons is obvious from the very nature of the assets of such companies. Their assets consist almost invariably of cash and marketable securities. They are liquid, mobile, and easily negotiable. These assets can be easily misappropriated, ‘looted,’ or otherwise misused for the selfish purposes of those in control of these enterprises. In the absence of regulating legislation, individuals who lack integrity will continue to be attracted by the opportunity available for personal profit in the control of the liquid assets of investment trusts and investment companies.8
Basically the problems flow from the very nature of the assets of investment companies. The assets of such companies invariably consist of cash and securities, assets which are completely liquid, mobile and readily negotiable. Because of these characteristics, control of such funds offers manifold opportunities for exploitation by the unscrupulous managements of some companies. These assets can and have been easily misappropriated and diverted by such types of managements, and have been employed to foster their personal interests rather than the interests of public security holders. It is obvious that in the absence of regulatory legislation, individuals who lack integrity will continue to be attracted by the opportunities for personal profit available in the control of the liquid assets of investment companies and that deficiencies which have occurred in the past will continue to occur in the future.9
These issues made national headlines in December 2008, when Bernard L. Madoff admitted to perpetrating a massive Ponzi scheme in which he convinced his clients that they owned securities that did not exist. For years, he evaded regulatory scrutiny until the scheme began to unravel. This scandal prompted the SEC to take actions to reduce the chance that a Madoff-style fraud would occur or go undetected in the future.10 While the SEC took steps to bolster its oversight and enforcement functions, it focused on rules designed to enhance the custody rules for investment advisers and broker-dealers. In December 2009, the SEC amended Advisers Act Rule 206(4)-2 (the “custody rule”),11 which was designed to provide greater assurance that investors’ accounts contain the funds that their account statements say they contain.
Among other things, the rule encouraged advisers to maintain their clients’ assets with independent custodians. For investment advisers who can control their clients’ assets, the rules require enhanced procedures, such as surprise asset-counts, third-party reviews and audited financial statements. To be sure, when the U.S. Congress enacted the 1940 Act and the Advisers Act, it clearly did not contemplate, or could even dream of, how the law would apply to digital assets such as cryptocurrencies or utility tokens. But the basic concerns of preventing fraud or misappropriation are just as valid today as they were in 1940. The only difference, of course, is that we are now attempting to apply 80-year-old laws designed to protect assets consisting of cash and securities to an entirely new class of digital assets created by a technology that did not exist at the time the laws were written.
Rule 206(4)-2 under the Advisers Act defines custody to mean “holding, directly or indirectly, client funds or securities, or having any authority to obtain possession of them.” The regulation provides that a registered investment adviser has custody of an asset “if a related person holds, directly or indirectly, client funds or securities, or has any authority to obtain possession of them, in connection with advisory services you provide to clients.”
• any arrangement (including a general power of attorney) under which the registered investment adviser is authorized or permitted to withdraw client funds or securities maintained with a custodian upon your instruction to the custodian; and
• any capacity (such as general partner of a limited partnership, managing member of a limited liability company or a comparable position for another type of pooled investment vehicle, or trustee of a trust) that gives the registered investment adviser or its supervised person legal ownership of or access to client funds or securities.
A threshold question is: does the SEC’s custody rule apply to digital assets? The answer depends on the facts and circumstances.
The SEC’s Division of Investment Management has said that Rule 206(4)-2 does not apply to an adviser to the extent that it manages assets that are “not funds or securities.”12 Does this mean that advisers to clients or funds that invest in Bitcoin are free to hold these assets in personal digital “wallets” without regard to federal regulation? If not, to what standard will an adviser be held?
The answer, of course, depends on whether cryptocurrencies are “funds or securities” for purposes of Rule 206-4(2). In light of the legislative history, which makes the protection of investors’ assets a priority, it is possible that most, if not all, digital assets would be considered “funds or securities,” at least for purposes of the Advisers Act and the custody rule. The matter, however, is not free from doubt.
The first step in analyzing the legal requirements for the custody of assets is to determine the nature of the investment adviser. The two threshold questions are:
• What law applies? That is, is the adviser an “investment adviser” as defined in the Advisers Act?
• If yes, is the adviser registered or required to be registered under the Advisers Act?
• A natural person, directly or in a managed account.
• A pooled investment vehicle that is not an investment company, such as a hedge fund, private equity fund, or other private fund.
• A pooled investment vehicle that is registered as an investment company.
• A regulated entity such as a broker-dealer, bank or investment adviser.
• An operating company.
• Other pooled investment vehicles that might be commodity pools that otherwise would be investment companies but for an exemption under the 1940 Act.
• engages in the business of advising others, directly or indirectly,
• as to the value of securities or as to the advisability of investing in securities,
• for compensation.
If you satisfy each of these three elements, you are an investment adviser for purposes of the Advisers Act unless you fall within one of the statutory exemptions.13 If you fall within the definition of an investment adviser, the next step in the analysis is to determine whether you are required to register under the Advisers Act.
This analysis is important, because a person that falls within the statutory definition of an investment adviser (a) is subject to regulation by the SEC, and (b) meets certain statutory thresholds or otherwise is required to register with the SEC, the person may be subject to the substantive provisions of the Advisers Act and its rules, including Rule 206(4)-2 (the SEC rule that applies to the custody of client assets).
Is the adviser providing advice to anyone about securities? For example, an adviser that solely provides investment advice about “commodities” would not be an investment adviser. For purposes of this discussion, we will assume that a “pure cryptocurrency,” such as Bitcoin or Ethereum, is a commodity, and not a security.14 Thus, an investment adviser that only provides advice to persons that invest in Bitcoin or Ethereum would not be an investment adviser, because these cryptocurrencies are not securities.15
The answer may be different if the investment adviser is providing advice about a derivative, the reference asset of which is a cryptocurrency. In that case, the advice may relate to a security (e.g., a structured note that links a return to a benchmark reference cryptocurrency or shares of a trust that holds cryptocurrency) or a commodity-related instrument that is regulated under the Commodity Exchange Act (e.g., a forward, future, put, call, straddle, swap, etc. relating to a cryptocurrency).
If the entity is providing advice with respect to securities, the entity may have to register with the SEC, depending on whether the person: (a) meets the statutory thresholds that permit registration; (b) is required to register by the Advisers Act; or (c) is eligible for status as a an “exempt reporting adviser.”16
• intrastate advisers, that is, advisers whose clients all reside in the state in which the adviser maintains its principal place of business;
• advisers whose only clients are insurance companies;
• “foreign private advisers,” which generally are advisers that (a) have no place of business in the U.S., (b) have fewer than 15 clients and investors in private funds in the U.S., (c) have less than $25 million in assets under management attributable to those clients and investors, and (d) do not hold themselves out as investment advisers in the U.S.;
• charitable organizations and plans;
• certain commodity trading advisors registered with the Commodities Futures Trading Commission (“CFTC”);
• private fund advisers, which generally are advisers solely to private funds that have less than $150 million in assets under management in the U.S.;
• venture capital fund advisers; and
• advisers to small business investment companies (SBICs).
Exempt reporting advisers, and investment advisers that fall within the definition but are not required to register are, however, nonetheless subject to the anti-fraud provisions of the Advisers Act, not to mention their fiduciary obligations to those clients under federal law. This includes state-registered investment advisers and investment advisers that are not required to register anywhere. While these investment advisers are not subject to the custody rule, it is reasonable to presume they still must exercise care and prudence in maintaining or arranging for the custody of their clients’ digital assets, including a responsibility to disclose related risks.
We discuss some of the challenges that investment advisers face in maintaining custody of digital assets below.
Rule 206(4)-2, the custody rule under the Advisers Act, applies to investment advisers registered, or required to be registered with the SEC (“RIAs”) that have “custody” of client funds or securities.
How does a qualified custodian maintain custody of client assets? The custody rule defines what entity can serve as a custodian, and prescribes specific steps that investment advisers with custody of client assets must take. Rule 206-4(2), however, stops short of specifying how a custodian must safeguard—or maintain custody of—the client’s assets.
As noted, an RIA is deemed to have “custody” of client assets if the RIA (or its related person) directly or indirectly holds client funds or securities, or has any authority to obtain possession of them.17 This authority can arise out of custodial or advisory arrangements. For example, an adviser that has access to a client’s private key to a cryptocurrency holding could be deemed to have access to the client’s asset, even if the same key is held by a third-party custodian. Depending on the facts and circumstances, the SEC staff has said, “custodial agreements could impute advisers with custody they otherwise did not intend to have.”18 Other arrangements in which an RIA is presumed to have custody of client assets include when an RIA or an affiliate acts as general partner or managing member to a private fund.
Put another way, it would be difficult for an RIA to avoid having custody of client funds and securities unless an RIA neither holds, nor has authority to obtain possession of, client funds and securities, including digital assets. When an RIA or its related person is deemed to have custody of client funds or assets, it must comply with certain requirements under Rule 206(4)-2(a), unless an exception in Rule 206(4)-2(b) applies. Unless the RIA qualifies for such an exception, an RIA that fails to comply likely violates the anti-fraud provisions of the Advisers Act.19
• in a separate account for the client under the client’s name; or
• in accounts that contain only the client’s funds and securities, under the RIA’s name as agent or trustee for the client.
• Many federal and state chartered banks.
• Registered broker-dealers holding client assets in customer accounts.
• Registered futures commission merchants holding client assets in customer accounts (but generally only with respect to futures contracts and other securities incidental to transactions in futures and related options).
• Foreign financial institutions that customarily hold financial assets for customers, provided that they keep advisory clients’ assets in customer accounts segregated from its proprietary assets.20
Account statement requirement. Rule 206(4)-2(a)(3) requires that the qualified custodian send account statements to each client for which it maintains funds or securities, unless an exemption applies. The statements, which must be sent at least quarterly, must identify the amount of funds and each security in the account at the end of the period, and all transactions during the period. RIAs must “have a reasonable basis, after due inquiry” for believing that the qualified custodian has sent the required account statements. This necessarily entails due diligence. Advisers have the option of sending their own account statements to their clients, in addition to those required to be sent by the qualified custodian. In this event, the notice to clients (summarized above) must include a statement “urging the client to compare the account statements from the custodian with those from the adviser.”21
When the RIA (or a related person of the RIA) serves as general partner or the equivalent of a pooled investment vehicle, the qualified custodian must send the account statement to each beneficial owner of the fund.22 This is so unless the audit exception for pooled investment vehicles (described below) applies.
Surprise audit requirement. Under Rule 206(4)-2(a)(4), at least once during each calendar year, RIA and “related person” custodied funds and securities must be verified by actual examination in a “surprise audit,” unless an exemption applies. The surprise audit—which is really a securities count and not a traditional “audit” of financial statements—must be conducted by an independent public accountant at a time be chosen by the accountant without prior notice or announcement to the RIA and that is irregular from year to year.
The written agreement must require the independent public accountant to: (a) file a certificate on Form ADV-E within 120 days of the examination date, stating that it has examined the funds and securities, and describing the nature and extent of the examination; (b) notify the SEC within one business day of any findings of “material discrepancies” during the examination; and (c) notify the SEC by filing Form ADV-E accompanied by certain statements regarding the registration if the independent public accountant resigns, or is dismissed, removed or terminated.23
Surprise audits of digital assets may pose significant challenges for independent auditors, who must validate that the private key actually represents ownership of a cryptocurrency without the benefit of traditional ownership indicia supported by securities registrars, control practices associated with regulated securities intermediaries, known and trusted parties to receive verification requests, etc.
(b) by an independent auditor that is registered with and subject to regular inspection as of the commencement of the engagement, and as of each calendar year-end, by the Public Company Accounting Oversight Board (“PCAOB”) in accordance with its rules; and
(c) upon liquidation, and distributes its audited financial statements prepared in accordance with generally accepted accounting principles (“GAAP”) to all limited partners (or members or other beneficial owners) promptly after the completion of the audit.
Independent advisers or related parties acting as qualified custodians. RIAs that maintain custody of client funds or securities, directly or through a related person that has actual rather than deemed custody (i.e., those acting as a qualified custodian) “in connection with” advisory services, must comply with two requirements that require the use of independent public accountants.24
Second, the internal control report must be prepared by an independent public accountant. The internal control report must include an opinion of a PCAOB-registered and inspected independent public accountant “as to whether controls have been placed in operation as of a specific date, and are suitably designed and are operating effectively to meet control objectives relating to custodial services, including the safeguarding of funds and securities held by either the RIA or a related person on behalf of the RIA’s advisory clients, during the year.” The independent public accountant must verify that the funds and securities are reconciled to a custodian other than the RIA or its related persons. A copy of any internal control report obtained or received is subject to record-keeping requirements.25
Non-U.S. advisers. Generally, non-U.S. RIAs with a principal place of business outside of the U.S. are not subject to the custody rule with respect to their non-U.S. clients. This includes a client that is a non-U.S. fund (organized outside the U.S.), whether or not the fund has U.S. investors.26
How does a qualified custodian maintain custody of client assets? The custody rule defines what entity can serve as a custodian, and prescribes specific steps that advisers with custody of client assets must take. Rule 206-4(2), however, stops short of specifying how a custodian must safeguard—or maintain custody of—the client’s assets. The lack of specificity has not been an issue for registered investment advisers that are deemed to have custody of traditional assets, such as stocks, bonds, futures contracts, or derivatives contracts. The custody rule, however, leaves open the question of how to provide custody for digital assets.
Section 17(f) of the 1940 Act and its regulations govern how registered investment companies must maintain custody of their assets.27 This section requires a registered fund to maintain its securities and similar investments with certain types of custodians under conditions designed to assure the safety of the fund’s assets.28 While the section addresses custody of fund assets by certain banks, broker-dealers and futures commission merchants (“FCMs”), as well as securities depositories, unsurprisingly it does not specifically address custody of digital assets.
Notably, Section 17(f)(1) refers to “securities and similar investments,” which is a broader category of assets than covered by the custody rule under the Advisers Act.
• a company that is a member of a national securities exchange, subject to the SEC’s rules; or
• the investment company itself, subject to the SEC’s rules.
When Congress enacted Section 17(f), of course, no-one anticipated how it would apply to digital assets. The term “and similar investments,” however, can readily be read to include digital assets.
Rule 17f-2(a) provides that “[t]he securities and similar investments of a registered management investment company may be maintained in the custody of such company only in accordance with the provisions of this section.” While the rule is deemed largely unworkable by the industry, it is in any event not clear how an investment company itself could take custody of digital assets without running afoul of the other provisions of the 1940 Act.
Rule 17f-629 generally provides that investment companies may “place and maintain cash, securities, and similar investments with a Futures Commission Merchant in amounts necessary to effect the Fund’s transactions in Exchange traded futures contracts and commodity options,” subject to certain conditions to safeguard the assets.
In sum, a registered investment company can comply with the requirements of Section 17(f) by placing digital assets in the possession of a bank, a broker-dealer that is a member of a national securities exchange, or a securities depository.
Funds that utilize certain derivatives related to digital assets (e.g., swaps, futures, options) can maintain custody with the futures commission merchant, but the custody arrangements present challenges when the derivative calls for physical settlement of the underlying asset, which we discuss below.
Funds that invest in digital assets directly or indirectly through derivatives must ensure that their compliance policies and procedures and disclosures address, among other things, the attendant risks.
Custody of “traditional” assets, such as stocks and bonds, is a straightforward matter. Back in days gone by, custodian banks would lock up a paper stock certificate or bond in a concrete-encased steel vault, access to which was restricted. To verify that the assets existed, auditors would enter the vault and literally pick up the certificates and count them. Technological (and legal) innovation led to “uncertificated” or “book-entry” securities, making paper certificates obsolete. Rather than issue paper stock certificates or bonds, issuers only record ownership of securities on their books. These securities are then often held electronically in “street name” through banks and brokers. This technology allows auditors to easily verify that an investor owns a particular security.
Investment advisers, whether or not they are registered with the SEC, and investment companies, face challenges when designing a custody arrangement that meets the regulatory requirements as well as protecting the client’s digital assets. Custody of digital assets involves different processes and procedures than custody of physical assets. For example, the risk of cybertheft is greater in the case of a digital asset, or the custodian may lose or misplace a private key. Similarly, if the custodian transfers the digital asset to an unauthorized person in error, it may not have recourse to recover the asset.30
Distributed ledger technology (“DLT”), such as blockchain, presents a novel challenge: how can a custodian—and an auditor—be certain that the custodian has actual and exclusive possession of a digital asset?
With these challenges in mind, let us begin by asking: how does an investment adviser maintain custody of a digital asset? To start, a registered investment adviser can satisfy the custody rule by maintaining the digital assets with a “qualified custodian.” To be sure, some qualified custodians have begun to accept digital asset custody accounts, and more are expected to enter that business.
In theory, the answer is simple: to prove you own or “have possession” of a digital asset, such as one bitcoin, you must have both a public key and a corresponding private key to prove you own the asset, much the same way access to a safe deposit box is accessible by the bank’s key and the depositor’s private key. The public key appears as a string of computer-coded entries on a digital ledger, representing a unique transaction that is added on as a “block” in a chain of other transactions, understood to represent a particular digital asset. In public blockchains, these digital entries are visible to and verifiable by all “nodes” that have access to the internet.
The private key, however, is a string of digits that is intended to be kept secret, a sort of electronic bearer instrument. Whoever has the private key to a particular digital asset can transfer it immutably and potentially anonymously to anyone. The challenge, then, is how to ensure that the digital asset in the safekeeping of a custodian are in fact safe, and cannot be stolen or misappropriated. Moreover, the fact that a custodian holds the private key may not be sufficient to demonstrate that, by itself, the custodian has exclusive control of the digital asset, because it may not be possible to prove that some other unauthorized person does not also have access to the private key.31
The answer to this riddle may involve a combination of physical and electronic solutions, combined with common sense-procedural safeguards and a measure of creative legal thinking.
Some special purpose banks assert that they have developed tailored platforms and procedures to ensure that they can keep digital assets safe. These procedures may include, among other things, maintaining digital assets in a “cold” or offline digital wallet, rather than on an “exchange,” requiring multiple electronic signatures in order to use or obtain access to the private key (sometimes referred to as “multisignature” or “multisig” and keeping the private key on a thumb drive or hard drive on a computer in a physical vault (and to wax metaphorically, encase the vault in concrete and surround it with an alligator-filled moat)). These physical safeguards, combined with layers of cybersecurity (e.g., no access by internet connection) may be reasonably sufficient (but by no means absolutely foolproof) to prevent bad actors from hacking in and stealing the private key.
In the final analysis, however, digital assets are essentially bearer assets. In general, a bad actor who obtains possession of the private key can, in theory, misappropriate the asset, no matter where the private key maintained.
Some industry participants have addressed this risk by proposing to obtain insurance against loss or theft of the digital asset. While insurance may address some of the counterparty and custody risks associated with cryptocurrencies, it may be costly and may not completely cover potential risks.
As already suggested, there also are other practical considerations that apply to the auditors of accounts holding digital assets. For example, how will independent auditors verify ownership of the digital asset? To whom would they send the audit letter requesting confirmation?
Challenges for registered investment companies.32 Registered funds face additional challenges if they wish to invest in digital assets.
Registered funds must also ensure that that the board of directors has sufficient information to provide meaningful oversight of the fund’s custody arrangements. Among other things, fund directors must approve the compliance policies and procedures of the investment company and its investment adviser, and also must approve of contractual arrangements with fund custodians. While some qualified custodians are willing to take custody of digital assets held by registered investment companies, they may face some challenges. For example, will the fund directors be satisfied that the custodian has adequate safeguards in place to protect the assets? Will the custodian’s limitations on liability be acceptable to the directors? Will the directors conclude that the cost of cryptocurrency custody is reasonable?
The staff of the SEC staff raised these issues in a letter dated January 18, 2018 by Dalia Blass, Director of the Division of Investment Management.33
These custody issues carry over to settlement of digital asset-related derivatives. That is, when a fund holds certain derivatives that are based on the value of an underlying digital asset, the futures commission merchant, which holds the derivative position for the benefit of the fund, will satisfy the qualified custodian requirements. But a fund that takes a long position in a Bitcoin futures contract may be required to accept Bitcoin when the contract matures, or to deliver Bitcoin to a futures commission merchant upon settlement of a short position. The Blass Cryptocurrency Letter noted the challenges that registered funds will face when taking positions in cryptocurrency-based derivatives:
The Blass Cryptocurrency Letter notwithstanding, on March 13, 2019, Cipher Technologies Management LP filed a registration statement on Form N-2 to register shares of a closed-end “interval” fund called the Cipher Technologies Bitcoin Fund.34 This fund would provide total returns available to direct investors in Bitcoin, less operating expenses. The fund would invest substantially all of its assets in a portfolio of Bitcoin or futures contracts or other derivatives providing similar economic exposure, as well as certain liquid securities to satisfy certain requirements of Rule 23c-3 under the 1940 Act (the “interval fund rule”), which requires interval funds to buy back a certain number of their shares at certain periods, or intervals (e.g., quarterly or semi-annually).
In a letter dated May 28, 2019, the staff of the Division of Investment Management asked the sponsor to withdraw the registration statement, because, among other things, “it is unclear whether the proposed fund would meet the definition of an investment company,” and therefore whether the fund can be registered under the 1940 Act. The staff asked the fund to provide an analysis of whether and how it would meet the definition of an investment company.35
In a letter dated June 14, 2019, the sponsor of the fund asserted that Bitcoin is a security for purposes of the Securities Act of 1933, the Securities Exchange Act of 1934, and yes, 1940 Act. Under the traditional Howey definition of a security, the sponsor argued, Bitcoin is a security because, for purposes of this fund, it consists of (i) an investment of money, (ii) in a common enterprise, (iii) with profits, (iv) to come solely from the efforts of others.36
The sponsor rejected that the argument articulated by William Hinman, Director of the SEC’s Division of Corporation Finance, in June 2018, that certain digital asset transactions do not represent securities offerings when “the network on which the token or coin is to function is sufficiently decentralized….” That is, Hinman said, there may be no investment contract when “purchasers would no longer reasonably expect a person or group to carry out essential managerial or entrepreneurial efforts.”37
Moreover, the sponsor of the fund asserted, it is irrelevant whether Bitcoin is a commodity, and by extension, it is irrelevant if the fund must register as a commodity pool operator. The sponsor concluded by stating that it respectfully declines the staff’s request that it withdraw its registration statement.
The debate over whether cryptocurrencies are securities for purposes of the federal securities laws is far from over, and in fact may have only just begun. Our summary of the Cipher Technologies registration statement highlights the challenges facing the industry and its regulators as RIAs and registered investment companies begin to invest in digital currencies.
To be sure, however, the current environment of persistent uncertainty cannot last; as the markets for cryptocurrencies and other digital assets mature, so too will custody standards. Custodians, auditors and other trusted parties that comprise the infrastructure for reliable custody in the securities markets will develop a battery of tailored policies, procedures and practices appropriate to this new and growing asset class, reasonably designed to minimize the potential of loss and maximise the protection of client assets.
2. For a general discussion of steps that the SEC could consider to address custody of digital assets, see Jay Baris, SEC Must Solve Its Cryptocurrency Conundrum, Fin. Times (May 2, 2019), (Hyperlink).
3. Investment Advisers Act of 1940, 15 U.S.C. §§ 80b–1–80b–21 (1940).
4. Investment Company Act of 1940, 15 U.S.C. §§ 80a–1–80a–64 (1940).
5. For a general discussion of blockchain issues for investment managers, see Jay G. Baris & Joshua Ashley Klayman, Blockchain Basics for Investment Managers: A Token of Appreciation, 51 Rev. Sec. & Commodities Reg. 67 (2018), (Hyperlink).
6. William Hinman, Director, SEC Div. of Corp. Fin., Remarks at the Yahoo Finance All Markets Summit: Crypto, Digital Asset Transactions: When Howey Met Gary (Plastic) (June 14, 2018), (Hyperlink).
7. The Advisers Act does not specifically address custody of client assets. Rather, the SEC addressed this issue in the Rule 206(4)-2 under the Advisers Act (the “custody rule”). 17 C.F.R. § 275.206(4)-2 (2010).
8. H.R. Rep. No. 76-2639 (1940).
9. S. Rep. No. 76-1744 (1940).
10. SEC, The Securities and Exchange Commission Post-Madoff Reforms (2009), (Hyperlink).
11. Investment Advisers Act Rule 206(4)-2, 17 C.F.R. § 275.206(4)-2 (2010).
12. The SEC staff has taken the position that if an adviser manages client assets that are not funds or securities, the custody rule does not require the adviser to maintain the assets with a qualified custodian. SEC Div. Of Inv. Mgmt., Staff Responses to Questions About the Custody Rule (2010), Question II.3, (Hyperlink). The issue now presented is whether the SEC staff considers cryptocurrencies to be “funds or securities” for purposes of the custody rule.
13. For example, family offices, banks, insurance companies and broker-dealers that provide advice incidental to their brokerage business, among others, are excluded from the definition of an investment adviser under the Advisers Act.
14. We are assuming that at least these two cryptocurrencies are not “securities” for purposes of the federal securities laws. See, e.g., Commodity Futures Trading Comm’n v. McDonnell, 287 F. Supp. 3d 213, 228 (E.D.N.Y. 2018) (“Virtual currencies can be regulated by CFTC as a commodity.”), (Hyperlink). In an April 26, 2018 testimony before the House Appropriations Committee, SEC Chair Jay Clayton confirmed this view. Testimony before the Financial Services and General Government Subcommittee of the House Committee on Appropriations, 115th Cong. (2018) (statement of Jay Clayton, Chairman, U.S. Securities and Exchange Commission) (“A pure medium of exchange, the one that’s most often cited, is – is Bitcoin. As a replacement for currency, that is – has been determined by most people not to be a security.”). We are aware of at least one public filing that challenges this notion.
15. We are aware of at least one public filing asserting that Bitcoin is a security for purposes of the Securities Act of 1933, the Securities Exchange Act of 1934 and Investment Company Act of 1940, challenging “conventional wisdom” and the sparse amount of legal precedent available. See Letter from Jacob E. Comer, Head of Regulatory and Compliance, Cipher Technologies Management LP, to Brent J. Fields, Assoc. Dir. of Disclosure Review and Accounting, Division of Investment Management (June 14, 2019), (Hyperlink). If the SEC accepts this argument, which is far from certain, the debate about custody of digital assets could change dramatically. The analysis of whether a particular digital asset is a security, in general or for purposes of custody requirements, is beyond the scope of this chapter and we save that debate for another day.
16. The provisions of the Advisers Act relating to whether an adviser is required to register are beyond the scope of this chapter.
17. Investment Advisers Act Rule 206(4)-2(d)(2), 17 C.F.R. § 275.206(4)-2(d)(2).
18. SEC Div. of Inv. Mgmt., Guidance Update No. 2017-01, Inadvertent Custody: Advisory Contract Versus Custodial Contract Authority (2017), (Hyperlink).
19. One notable exemption is that Rule 206(4)-2 does not apply with respect to mutual fund accounts of the RIA. See Rule 206(4)-2(b)(5), 17 C.F.R. § 275.206(4)-2(b)(5).
20. Investment Advisers Act Rule 206(4)-2(d)(6), 17 C.F.R. § 275.206(4)-2(d)(6).
21. Investment Advisers Act Rule 206(4)-2(a)(2), 17 C.F.R. § 275.206(4)-2(a)(2).
22. Investment Advisers Act Rule 206(4)-2(a)(5), 17 C.F.R. § 275.206(4)-2(a)(5).
23. Investment Advisers Act Rule 206(4)-2(a)(4)(iii), 17 C.F.R. § 275.206(4)-2(a)(4)(iii).
24. Investment Advisers Act Rule 206(4)-2(a)(6), 17 C.F.R. § 275.206(4)-2(a)(6).
25. Investment Advisers Act Rule 204-2(a)(17)(iii), 17 C.F.R. § 275.204-2(a)(17)(iii).
26. Exemptions for Advisers to Venture Capital Funds, Private Fund Advisers With Less Than $150 Million in Assets Under Management, and Foreign Private Advisers, Advisers Act Release No. IA-3222, 76 Fed. Reg. 39,645, 127 n.515 (June 22, 2011) (“[W]e do not apply most of the substantive provisions of the Advisers Act to the non-U.S. clients of a non-U.S. adviser registered with the Commission.”), (Hyperlink). See also Robert E. Plaze, Regulation of Investment Advisers by the U.S. Securities and Exchange Commission, 67 n.374 (June 2018), (Hyperlink).
27. Investment Company Act of 1940, 15 U.S.C. § 80a–17 (1958).
28. See generally Custody of Investment Company Assets with a Securities Depository, Investment Company Act Release No. IC-25934, 68 Fed. Reg. 8,437 (Feb. 13, 2003), (Hyperlink).
29. Custody of Investment Company Assets with Futures Commission Merchants and Commodity Clearing Organizations, Investment Company Act Release No. IC-22389, 61 Fed. Reg. 66,207 (Dec. 11, 1996), (Hyperlink).
30. In a joint statement dated July 8, 2019, the Division of Trading and Markets of the SEC and the Office of General Counsel of the Financial Industry Regulatory Authority summarized the challenges that broker-dealers face when broker-dealers take custody of digital assets for their customers. Although the joint statement applies to broker-dealers, the basic principles and challenges involving custody of digital assets apply equally to investment advisers. SEC Div. of Trading & Mkt. & Office of Gen. Counsel, Fin. Indus. Regulatory Auth., Joint Statement on Broker-Dealer Custody of Digital Asset Securities (July 8, 2019) (the “Joint Statement”), (Hyperlink).
31. Joint Statement, supra note 30.
32. For a discussion about digital asset-related exchange-traded products (ETPs), including exchange-traded funds (EFTs), see Baris & Klayman, In Pursuit of Perfection? A Primer of Ditigal Asset-Related ETPs, Blockchain and Virtual Currencies Briefing, Issue No. 1, June 2019, (Hyperlink).
33. Investment Company Institute & Securities Industry and Financial Markets Association, SEC Staff Letter, Engaging on Fund Innovation and Cryptocurrency-Related Holdings (Jan. 18, 2018), (Hyperlink) (the “Blass Cryptocurrency Letter”).
34. Cipher Technologies Bitcoin Fund, Registration Statement (Form N-2) (May 13, 2019), (Hyperlink).
35. Letter from Brent J. Fields, Assoc. Dir. of Disclosure Review and Accounting, Division of Investment Management, to Jacob E. Comer, Head of Regulatory and Compliance, Cipher Technologies Management LP (May 28, 2019), (Hyperlink).
36. Letter from Jacob E. Comer, Head of Regulatory and Compliance, Cipher Technologies Management LP, to Brent J. Fields, Assoc. Dir. of Disclosure Review and Accounting, Division of Investment Management (June 14, 2019), (Hyperlink).
37. Hinman, supra note 6.
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