The Adviser’s Fiduciary Duty and the Blass Letter

On January 18, 2018, Dalia Blass, Director of the SEC’s Division of Investment Management, wrote a letter addressed to the Investment Company Institute and the Securities Industry Financial Markets Association (the Blass Letter).

The Blass Letter focuses primarily on describing a number of potential issues (including, among others, valuation, liquidity, and custody) relating to investments in cryptocurrencies by mutual funds and exchange-traded funds.[1]

The Blass Letter did not expressly state that the SEC staff has similar concerns about investment advisers that manage cryptocurrency portfolios of clients other than mutual funds and ETFs (although, as we shall see in subsequent posts on this blog, these concerns do in fact apply to a large extent to investment advisers that manage other types of accounts).

Toward the end of the Blass Letter, however, the SEC staff asks:

“Are there particular challenges investment advisers would face in meeting their fiduciary obligations when investing in cryptocurrency-related funds on behalf of retail investors?”

Indeed, when it poses the following questions, the Blass Letter appears to suggest that retail investors may not be capable of understanding the risks associated with investing in crypto assets:

How would you weigh [the concerns articulated by the staff earlier in the Blass Letter] in considering whether offering a proposed fund is appropriate for the wide range of investors, including retail investors, who might invest in the fund? Would investors, including retail investors, have sufficient information to consider any cryptocurrency-related funds and to understand the risks?        

It seems that the answer to these questions is relatively straightforward: an investment adviser should be free to agree to manage a crypto asset account for a client—either by investing the client’s assets directly in crypto assets or investing such assets in crypto asset funds—as long three requirements are satisfied:

1. the adviser has made full and fair disclosure to the client of all material risks[2] associated with investing in crypto assets;
2. such disclosure is made in a manner that the client is capable of understanding it, and
3. the adviser otherwise adheres to the standards of care and loyalty to which it is subject in connection with managing the client’s portfolio.

The Blass Letter’s concern about the ability of retail investors to fully comprehend the risks associated with crypto investments appears to take its cue from the SEC’s analysis of certain types of conflicts of interest that “may be of a nature and extent that it would be difficult to provide disclosure that adequately conveys the material facts or the nature, magnitude and potential effect of the conflict necessary to obtain informed consent and satisfy an adviser’s fiduciary duty. In other cases, disclosure may not be specific enough for clients to understand whether and how the conflict will affect the advice they receive. With some complex or extensive conflicts, it may be difficult to provide disclosure that is sufficiently specific, but also understandable, to the adviser’s clients.”[3]

In other words, the SEC staff may be arguing in the Blass Letter that, just as there are certain conflicts of interest that may effectively be “beyond disclosure,” no disclosure regarding the risks associated with investing in crypto assets could ever be made in a manner that a retail investor can fully comprehend and that, as a result, it is never appropriate for an adviser to invest a retail client’s portfolio in (or recommend that a retail investor invest in) crypto assets.

If this is what the Blass Letter is arguing, I believe it has missed the mark. At the time the Blass Letter was written, the SEC staff was well aware that retail investors were significantly involved in acquiring crypto assets. As early as July 2013, the SEC issued its first “investor alert”—clearly addressed to retail investors—warning them about the potential risks associated with investing in crypto assets. By the time the Blass Letter was written, the SEC, FINRA, NASAA, the CFTC, the NFA and the CFPB had issued at least 21 more such alerts—all of which were clearly addressed to retail investors and many of which described those risks, in detail, in “plain English.” (A list of the various “investors alerts” published by these agencies to date can be found here.)

In light of this, I think it is difficult to argue that advisers should not invest in the crypto space on behalf of their retail clients because the associated risks can never be disclosed in a manner that a retail investor can fully comprehend. If the SEC and other financial regulators believe they are able to formulate crypto risk disclosure that retail investors can comprehend, what reason is there to believe that an adviser could not do the same?

---

[1]Although the Blass Letter notes that it addresses issues raised by funds that potentially focus on cryptocurrency-related products, it goes on to say that “other types of digital assets and related products could present similar issues.”

[2]The Blass Letter notes that: (1) SEC Chairman Jay Clayton has publicly stated that concerns have been raised that cryptocurrency markets, as they are currently operating, feature substantially less investor protection than traditional securities markets, with correspondingly greater opportunities for fraud and manipulation; (2) the SEC has also discussed concerns relating to the risk of fraud and manipulation in cryptocurrency markets in orders denying exchange proposals to list the shares of commodity trusts that would hold cryptocurrency; (3) a number of recent media reports have highlighted a range of possible vectors for potential manipulation of cryptocurrency markets; and (4) although some funds may propose to hold cryptocurrency-related products, rather than cryptocurrencies, the pricing, volatility and resiliency of these derivative markets generally would be expected to be strongly influenced by the underlying markets. 

We will specifically address crypto risk disclosure in a subsequent post on this blog.

[3]See IAA Release No. 4889 (Apr. 18, 2018) at pp. 17-18.