Securities Law and Digital Assets – Ideas From the SEC, FINRA Staffs

In recent months the key question regarding digital assets has been whether they are a security. The Commission furnished guidance on this by issuing a Section 21(a) report known as the DAO Report, discussed here. The approach of the agency centered on the application of the traditional Howey investment contract test to the particular circumstances surrounding the digital assets involved. Frequently, the question is resolved in the context of an enforcement action, many of which center on an offering fraud. See, e.g. U.S. v. Haddow, No. 1:17-mj-04939 (S.D.N.Y.) (terms like “blockchain” used to lure investors to offering fraud).

While many of the enforcement cases moved forward, other questions regarding the application of the federal securities laws to digital assets arose. Those questions run the gamut from registration to trading platforms, custody and record keeping.

Now the staff of the Division of Trading and Markets, the Office of the General Counsel and the Financial Industry Regulatory Authority have issued a joint statement addressing certain points regarding digital assets. The issues covered include: 1) Registration; 2) the Customer Protection rule; 3) books, records and financial reporting; and 4) the SIPIC. The discussion of these questions generally draws on the “historic approach to broker-dealer regulation and investor protection,” reiterating long established security principles meshed with the potential risks of digital currencies. Joint Staff Statement on Broker-Dealer Custody of Digital Asset Securities (July 8, 2019)(here).

“[T]o participate in the marketplace for digital asset securities [entities] must comply with the relevant securities laws,” the Statement begins. Firms transacting business in this space may be required to register as a broker-dealer and/or become a member of an SRO, typically FINRA. Firms which are not registered that intend to be involved with digital asset securities are thus seeking to register with the Commission and have submitted New Membership Applications to FINRA.

Other firms that are registered want to expand their businesses to include digital assets. Those entities should consider the FINRA rules that prohibit a firm from materially changing its business operations –“e.g. , engaging in material digital asset securities activities for the first time” – on this point. FINRA is currently considering applications such as this, according to the Statement.

Firms working in this area will also have to comply with the Commission’s Customer Protection rule which safeguards customer assets as do other broker-dealers. There may, however, be what the Statement calls “significant differences in the mechanics and risks associated with custodying traditional securities and digital asset securities.” The manner in which digital asset securities are issued and/or held, may create different kinds of risks. Those risks, as well as others that may be unique to digital assets, must be carefully assessed in determining how to comply with the Customer Protection rule. Indeed, those risks “could cause securities customers to suffer losses, with corresponding liabilities for the broker-dealer, imperiling the firm, its customers, and other creditors.”

Transact business in this area will also require firms to comply with the broker-dealer record keeping and reporting rules. Generally, those provisions require the firm “to make and keep current ledgers reflecting all assets and securities . . . and routinely prepare financial statements.” Firms involved with digital assets may find it difficult to apply these rules. As the Statement admits: “The nature of distributed ledger technology, as well as the characteristics associated with digital asset securities, may make it difficult for a broker-dealer to evidence the existence of digital asset securities for the purpose of . . .” the books and records provisions.

Firms registering in this area will, in addition, encounter SIPIC. Under that Act a broker-dealer that “fails to and is unable to return the customer property that it holds would be liquidated . . .” Customers are also eligible for up to $500,000 in protection if customer assets are missing. On the other hand if the digital asset security does not meet the definition of “security” under SIPA, and there is a failure to continue as a broker, “SIPIC protection likely would not apply and holders of those digital asset securities would have only unsecured general creditor claims against the broker-dealer’s estate.”

The Statement concludes by noting that “the Staffs encourage and support innovation in the securities markets and look forward to continuing to engage with investors and industry participants as the marketplace for digital asset securities develops.” This theme threads throughout the Statement as the staffs struggled to apply traditional securities law concepts to evolving digital assets. Those entering or participating in the digital securities space would be well served by carefully assessing the difficulties evident in the Statement.