Securities Litigation

This week, the SEC's Division of Investment Management issued a letter seeking industry and public input on custody issues arising from digital assets.

The "Custody Rule," Rule 206(4)-2 under the Advisers Act of 1940, provides it is a fraudulent act or practice to have custody of client assets, unless an adviser complies with Custody-Rule requirements, including among others, by a qualified custodian subject to annual independent audits.

The Division's recent Guidance Update on custody issues focused on inadvertent custody (e.g. where boilerplate in the adviser’s agreement with a custodian confers a power to withdraw or direct client assets beyond the adviser’s trading authorization).  See  https://www.sec.gov/investment/im-guidance-2017-01.pdf ("2017" Guidance Update).

Most securities trades settle by the simultaneous delivery of the purchased asset against payment ("DVP") through a trusted intermediary, like the Depository Trust Clearing Corporation ("DTCC").  But digital assets, like crypto-currencies, usually involve peer-to-peer ("P2P") transactions and settlement on a Blockchain.  The Division’s letter seeks industry and public input on non-DVP settled assets, asking:

• What types of instruments trade on a Non-DVP basis? How do these instruments trade?
• Describe the risks of misappropriation or loss associated with various types of Non-DVP trading. What controls do investment advisers have in place to address the risks of misappropriation related to such trading? What types of independent checks, other than a surprise examination, do investment advisers use currently to test these controls?
• Are there particular types of securities transactions settled on a Non-DVP basis that present greater or lesser risk of misappropriation or loss?
• What role do custodians play in the settlement process of Non-DVP trading? What role do they play in mitigating risks of misappropriation or loss arising from such trading?
• For advisers who currently obtain surprise examinations, what is the marginal cost of adding accounts that trade on a Non-DVP basis to the list of client accounts provided to the accountant performing the surprise examination of a sample of client accounts?
• What challenges do investment advisers have in obtaining surprise examinations regarding Non-DVP traded securities? How do advisers to unaudited private funds that are subject to surprise examinations address these challenges?
• Are there types of external checks that could be more effective and less costly than surprise examinations with respect to Non-DVP traded securities?
• To what extent do Non-DVP assets appear on client account statements from qualified custodians? To what extent does an investment adviser have any influence over, or input into whether and how such assets appear on account statements? Are there any assets that trade on a Non-DVP basis that would not appear on a qualified custodian’s account statements?
• To what extent could evolving technologies, such as Blockchain/distributed ledger technology ("DLT"), provide enhanced or diminished client protection in the context of Non-DVP trading?

Specifically, the Staff seeks further information on digital assets, including:

• Practices and challenges;
• Whether advisers include digital assets as "funds" or "securities" within assets under management (and other regulatory reporting) and challenges associated with the issue;
• P2P settlement practices and issues.

Interested parties should submit comments to IMOCC@sec.gov , with "Custody Rule and Non-DVP Trading" or "Custody Rule and Digital Assets" in the subject line.

The March 12, 2019 letter, "Engaging on Non-DVP Custodial Practices and Digital Assets," is here.

Thomas K. Potter, III (tpotter@burr.com) is a partner in the Securities Litigation Practice Group at Burr & Forman, LLP. Tom is licensed in Tennessee, Texas, and Louisiana. He has over 33 years' experience representing financial institutions in litigation, regulatory and compliance matters. See attorney profile.

© 2019 by Thomas K. Potter, III (all rights reserved).