SEC Securities Rule Proposal: What a Crypto Investment Advisor Needs to Know | Lowenstein Sandler LLP

SEC Securities Rule Proposal: What a Crypto Investment Advisor Needs to Know |  Lowenstein Sandler LLP

Highlights of the proposed rule:

On February 15, 2023, the US Securities and Exchange Commission (SEC) issued a proposed rule amendment (the Proposed Rule) redesignating the “Custodian Rule” (ie, Rule 206(4)-2 of the Investment Advisers Act of 1940, as amended) (the Custodian Rule) as the “safety rule” (the safety rule). The proposed rule would require investment advisers (advisers) and qualified custodians (qualified custodians) to take enhanced steps to protect clients’ assets, including with respect to crypto-assets.

Custody; Qualified trustees

The proposed rule would expand the circumstances in which an adviser is considered to have custody of client assets and thus an obligation to protect those assets. The proposed rule would retain the custodian rule’s definition of “custodian,” which exists when either (1) the adviser has physical possession of the assets; (2) an arrangement exists under which the adviser is authorized or permitted to withdraw the assets held by a custodian or (3) the adviser has a capacity that gives it (or its supervised persons) legal ownership of or access to the assets, but that would expand the definition to establish that “custodian” also exists when there is an arrangement where the adviser has discretionary authority to transfer beneficial ownership of the client’s assets.

The proposed rule would continue to allow banks or savings associations, registered broker-dealers, registered futures commission dealers, and certain foreign financial institutions to act as qualified custodians, but in a change from current rules, such custodians must have “possession or control” of client funds pursuant to a written agreement between the Eligible Custodian and the Adviser (or between the Client and the Adviser if the Adviser acts as the Eligible Custodian). An Eligible Custodian will have “possession or control” of a crypto-asset if it holds private keys for the wallet containing crypto-assets sufficient to to ensure that the adviser is unable to change beneficial ownership of crypto assets without the custodian.

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Application for crypto advisors

The SEC recognizes that many Crypto Advisers currently take the position that the Crypto Assets they advise on are neither funds nor securities, and therefore their actions with respect to such assets do not implicate the requirements of the Custodian Rule; However, the SEC makes clear in the proposed rule release that it believes most cryptoassets are actually either funds or securities, and therefore subject to the current depository rule.

Trading in crypto assets

The proposed rule has significant implications for the way most crypto advisors currently hold and trade client crypto assets on centralized and decentralized exchanges. Currently, many crypto-advisors hold client crypto-assets with non-qualified custodial exchanges, have access to a client’s (eg an individual’s or fund’s) crypto-wallet through smart contract or other means (such as through API key access), and are generally authorized to execute trades on behalf of its customers through this access, either on a discretionary or non-discretionary basis. Going forward, this type of arrangement will no longer be possible.

To satisfy the requirements of the proposed rule, crypto advisors would be able to continue these current activities only to the extent that the client’s assets are held (1) in a wallet maintained by a qualified custodian, and (2) in a manner sufficient to ensure that the advisor are unable to change beneficial ownership of cryptoassets without the qualified custodian.

This poses a challenge for many crypto advisors who have until now mainly relied on various exchanges and crypto asset platforms that do not constitute qualified custodians. In addition, these crypto advisors have historically relied on technology to exercise control and use automated and/or algorithmic trading strategies (automated strategies). If the proposed rule is adopted without any significant changes, crypto advisors will (1) potentially need to revamp their current custodian solutions to use qualified custodians and (2) adjust the way they execute automated strategies (through a qualified custodian).

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In light of these changes and the requirements under the proposed rule, crypto-advisers who rely on automated strategies should consider whether their automated strategies can continue to function as intended. For example, if a crypto advisor has built its automated strategies based on the assumption that the underlying crypto assets do not constitute funds or securities and are therefore not subject to the custodian rule (ie, there is no need for a qualified custodian), the Crypto Adviser must determine whether its automated strategies will be significantly affected by (1) moving to use a qualified custodian structured to satisfy the proposed rule and (2) the limited cryptoassets currently available for trading through existing qualified custodians (as opposed to their non-qualified custody counterparties).

Other notable changes and considerations

Some crypto advisors engage in buying or selling crypto-asset securities through private placements. Under the current custodian rule, crypto advisors are generally not required to use qualified custodians for private securities in cryptoassets – rather, they can rely on the privately offered securities exemption (private securities exception). The proposed rule largely maintains these requirements, but clarifies that a security in cryptoassets does not qualify an adviser to rely on the private securities exemption because the securities must only be registrable on the issuer’s (or its transfer agent’s) non-public books in the name of the client . Since crypto-asset securities are issued on public, permissionless blockchains, they do not satisfy the conditions of the Private Securities Exemption under the proposed rule.

Therefore, if an adviser seeks to purchase such crypto-asset securities on behalf of its clients, it must do so through a qualified custodian under the proposed rule. In addition, in the event a fund or client owns a beneficial interest in a warrant or other convertible security that qualified under the Private Securities Exemption (including a regular token warrant), in the event a conversion event occurs that converts the securities into cryptoassets. , the adviser would be required to maintain custody of such converted assets with a qualified custodian in accordance with the requirements under the proposed rule.

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