Welcome to the Non-Fungible Insights: Blockchain Decrypted Blog

We inaugurate the Non-Fungible Insights: Blockchain Decrypted with a series of blog posts that address significant issues faced by investment advisers registered with the Securities and Exchange Commission (SEC) under the Investment Advisers Act of 1940 (IAA) that wish to manage client portfolios consisting in whole or in part of crypto assets (or provide advice to clients with respect to investments in crypto assets). From time to time, we may interrupt that ongoing discussion to the extent necessary to address new and important legal and regulatory developments in the cryptosphere.

For the sake of simplicity, the Crypto Law Corner will define “crypto assets” to include cryptocurrencies and other virtual coins and tokens (including virtual coins and tokens offered in a so-called initial coin offering (ICO) or pre-ICO or in a so-called securities token offering (STO)), and any other asset that consists of, or is represented by, records in a blockchain or distributed ledger (including any securities, commodities, software, contracts, accounts, rights, intangible property, personal property, real estate, or other assets that are “tokenized,” “virtualized,” or otherwise represented by records in a blockchain or distributed ledger).

Set forth below is a very brief outline of the issues that we will discuss at length in future posts:

AN ADVISER’S FIDUCIARY DUTY WITH RESPECT TO CRYPTO ASSETS

In a letter from the Staff of the SEC’s Division of Investment Management (IM) dated January 18, 2018 and addressed to the Investment Company Institute and the Securities Industry and Financial Markets Association, IM asks the following question (among others):

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

Is this a legitimate question, or simply a shot across the bow of investment management firms that wish to manage investments in crypto assets on behalf of, or recommend investments in crypto assets to, their clients?

WHEN IS A CRYPTO ASSET A “SECURITY,” AND WHY DOES THAT MATTER?

Some crypto assets are clearly securities and some are not. Many must be analyzed on a case-by-case basis to determine whether or not they are securities

Drawing distinctions between different types of crypto assets is important because the regulatory treatment of a particular crypto asset depends in large part on whether or not it is a security. This will become apparent from our discussion of the various matters discussed below. 

FORM ADV REGISTRATION CONSIDERATIONS; FORM ADV AND FORM PF REPORTING CONSIDERATIONS

In many situations, the key component in determining whether an investment adviser is eligible or required to register with the SEC, or to withdraw its SEC registration, is the amount of the adviser’s “regulatory assets under management” (RAUM).

In addition to registration status, many of the reporting items on SEC Forms ADV Part 1A and Form PF require a registered investment adviser to calculate its RAUM.

When must an investment adviser include or exclude particular types of crypto assets from its calculation of RAUM for registration and reporting purposes? 

VALUATION CONSIDERATIONS

Sound valuations of assets under management are important for several reasons:

• the adviser’s registration and reporting obligations with respect to “regulatory assets under management” are based on such valuations;
• the advisers’ fees are based on such valuations;
• such valuations are integral to an adviser’s presentation of its performance; and
• such valuations arenecessary to ensure proper NAVs at which investors invest in and withdraw from commingled investment products on a monthly, quarterly, or other periodic basis.

What particular challenges, if any, does an investment adviser face in valuing crypto assets for these purposes? 

RISK DISCLOSURE CONSIDERATIONS

What risks must an adviser disclose to clients (in Form ADV Part 2 or elsewhere) if the adviser wishes to manage client portfolios consisting in whole or in part of crypto assets (or wishes to recommend investments in crypto assets to clients)?

CODE OF ETHICS CONSIDERATIONS

What types of crypto assets are subject to the pre-clearance and/or reporting (both holdings and transactional) requirements of Rule 204A-1 under the IAA?

CUSTODY CONSIDERATIONS

How do advisers that manage portfolios consisting in whole or in part of crypto assets assure themselves that they are in compliance with Rule 206(4)-2 under the IAA—the so-called Custody Rule.

SPECIAL CONSIDERATIONS FOR ADVISERS TO REGISTERED CRYPTO FUNDS

Will these funds every be permitted to invest in crypto assets?  

OTHER ISSUES/CONSIDERATIONS

• Office of Compliance Inspections and Examinations exam priorities in crypto space.
• Updating compliance policies and procedures to address particular issues presented by investing in crypto assets on behalf of, or recommending investments in crypto assets to, clients.
• Application of Section 206(3) of the IAA (which addresses so-called “agency cross” trades and “principal” trades) to crypto assets.
• Accepting funds from investors in the form of cryptocurrencies or other crypto assets.
• For investment advisers that are also registered with the CFTC and are NFA members, the special reporting and disclosure requirements that apply to such investment advisers in connection with investing in crypto assets on behalf of, or recommending investments in crypto assets to, clients.
• For investment advisers that are also registered with the SEC as broker-dealers, issues arising under the SEC’s “customer protection” and “net capital rules”) (e.g., SEC Rule 15c3-3; FINRA Rule 4160)
• Additional considerations that apply to investment advisers in connection with investing in crypto assets on behalf of, or recommending investments in crypto assets to, clients that are subject to ERISA.