The Division of Investment Management (the “Division”) of the Securities and Exchange Commission (the “SEC”) has stringent requirements for companies that are registered investment advisers (or should be so registered) with respect to client assets. These rules of long-standing are known as the “Custody Rule,” which provides that it is wrongful conduct for an adviser having custody of client assets to fail to follow the Custody Rule. The Custory Rule is based on long-existing securities market transactional rules termed “Delivery versus Payment” or “DVP.” The origins of DVP necessarily were based on a physical document or physical record to be delivered in exchange for payment. The Custody Rule is found at Code of Federal Regulations Volume 17 Section 275.206(4)-2, Custody of funds or securities of clients of investment advisers.
The Custody Rule is at the heart of the protections afforded to investors by the Investment Advisers Act. The concern is that an adviser having custody (that is, effective control over disposition of the assets) may be tempted to misappropriate assets over which it has custody or otherwise commit nefarious acts with respect to custodied assets. In the words of the SEC: “When investment advisers have ‘custody,’ or access to client funds or securities, there is a risk of misappropriation or misuse of these assets.”
What factual elements constitute custody? In 2003, the SEC amended the definition of “custody”in a warning directed to investment advisers, to include, among other factors: “Any arrangement (including a general power of attorney) under which you [an investment adviser] authorized or permitted to withdraw client funds or securities maintained with a custodian [i.e., broker-dealer] upon your instructions to the custodian.” Custody is broadly defined, and includes not just physical possession of client securities but authority and access to client securities and funds. An important exception is the “authorized trading” exception, under which instructions given to a broker-dealer or custodian to effect or settle trades do not constitute “custody.” Built into the compliance regime is the possibility of the “surprise examination” by accountants. There is an issue as to whether the authorized trading exception applies to trades that are not DVP.
Now the SEC has discovered that digital assets do not fit neatly into the DVP framework. The conundrum of assets that are valuable, yet not subject to DVP, has left the Division asking many questions. In its Letter from Paul G. Cellupica (Deputy Director and General Counsel of the Division) of March 12, 2019 to Karen Barr of the Investment Advisers Association the Division requests guidance on a long list of issues. The SEC notes that over the past 15 years the Division Staff has observed that non-DVP trades and other issues have given rise to uncertainties; hence, this letter, asking for comments on, among other items, the following.
- What types of instruments trade on a non-DVP basis and how do they trade? [We may ask why the SEC does not know the answer to this question.]
- Are there particular types of securities transactions settled on a non-DVP basis that present a greater or less risk of misappropriation or loss?
- Are digital assets “funds” or securities” or neither?
- What is the extent to which evolving technologies, e.g., blockchain and distributed ledge technology (“DLT”), provide enhanced or diminished protections for investors in the context of non-DVP trading?
- The Division is particularly interested in how the Custody Rule applies to DLT. How is DLT used to record ownership of assets? Further, “the inability to restore or recover digital assets once lost, the generally anonymous nature of DLT transactions, and the challenges posed to auditors in examining DLT and digital assts,” are alll problem areas.
- Should there be special disclosures to clients with respect to digital assets?
- What is the role of custodian with respect to the settlement of non-DVP assets? To what extent do digital assets appear on client account statements sent by qualified custodians? To what extent does an investment adviser have influence or input in what goes into the account statements? Are there any assets trading on a non-DVP basis that do not appear in a qualified custodian’s account statements?
- How does the surprise examination work with respect to digital assets? How do hedge funds deal with this requirement? Are there additional costs with respect to the surprise audit when digital assets are held?
- “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 currently use to test these controls?”
- In peer-to-peer digital asset transaction (that is, no broker-dealer or other intermediary) how does the settlement function work? Further, what is the settlement process for transaction in digital assets that are conducted in intermediated transactions?
These questions and more indicate that the Division has a great deal to learn about digital assets. The world of non-DVP transactions is so far removed from the Division’s knowledge base that it is unsettling to us, at least, to see how far removed the Division is from current developments in the financial markets. Digital assets are hardly a new asset class and the Division’s failure to keep abreast of developments is regrettable.
To us, the fact that there is a lack of guidance about how surprise examinations are conducted, with respect to non-DVP transactions, is unfortunate. Consideration to requiring additional factual backup in such cases seems approriate under the circumstances.