1. On March 30, 2023, the SEC settled charges against Sapere Wealth Management, LLC, a Matthews, North Carolina-based investment adviser, and its principal, Scott Trease, for unsuitably recommending that three clients invest $7.3 million in risky, alternative-investment deals. Sapere and Trease did not reasonably understand the investments and thus lacked a reasonable basis to recommend them to clients. Sapere and Treaseh was ordered to pay a $100,000 civil penalty. https://www.sec.gov/litigation/litreleases/2023/lr25681.htm
2. On March 29, 2023, the SEC charged former broker Surage Perera and his firm, Janues Capital Incorporated, with defrauding an investor out of millions by lying about investment opportunities and strategies, concealing trading losses, and using funds received from others to give the victim the promised returns in Ponzi-like fashion. Perera, a Long Island, New York resident, falsely told an investor that Janues had access to specific restricted securities at discounted prices though connections with large, institutional investors. Perera claimed to also exercise a trading strategy, which he referred to as ‘Options Straddles,’ that would not only prevent any trading losses but also guarantee returns on some of the investments of up to 9 percent with the potential for returns of 50 percent. Perera and Janues used at least $3.57 million of the investor’s $4.3 million funds to engage in highly speculative, leveraged trading, and ultimately misappropriated at least $3.3 million. Perera engaged in more than $2.5 billion in securities transactions, with nearly $3 million in trading losses. Perera then concealed the misappropriation and losses by providing the investor with phony confirmations and account statements that falsely showed the expected returns. Perera further attempted to hide the losses by using funds received from others sources to make Ponzi-like payments to the investor. This matter is being litigated. https://www.sec.gov/litigation/litreleases/2023/lr25679.htm
3. On March 28, 2023, the SEC entered a final judgment against Massachusetts-based investment adviser, James Couture in connection with the SEC’s allegations that he engaged in a deceptive scheme to misappropriate a total of approximately $2.9 million from unsuspecting clients. Couture, while operating an investment advisory and brokerage business, fraudulently prompted his advisory clients to sell portions of their securities holdings in order to fund large money transfers to an entity that, unbeknownst to his clients, Couture owned and controlled. For each transaction, Couture obtained client authorization by falsely claiming that the proceeds would be reinvested for the clients’ financial benefit. Couture’s purpose in arranging these transactions was to divert the sale proceeds for his own benefit. Couture took assets from his other advisory clients through a web of third-party accounts to disguise that he was misappropriating money from one client to replace funds he had previously stolen from another. This matter is being litigated. https://www.sec.gov/litigation/litreleases/2023/lr25678.htm
4. On March 27, 2023, the SEC’s Division of Examinations published a Risk Alert discussing the typical focus areas reviewed during examinations of newly-registered advisers and shares staff observations regarding compliance policies and procedures, disclosures, and marketing practices. The full risk alert can be found here: https://www.sec.gov/files/risk-alert-newly-registered-ias-032723.pdf.
- Examination Scope
The Division has prioritized examining newly-registered advisers within a reasonable period of time after the adviser’s SEC registration has become effective.
- General information to provide the staff with an understanding of the adviser’s business and operations, such as: (1) organizational charts; (2) documentation to support eligibility for SEC registration; (3) information about ownership and control of the adviser and its affiliates; (4) information about current and former advisory personnel, such as the reasons for departure for former personnel (if available), and the roles, responsibilities, physical locations for current personnel; (5) financial information, including the balance sheet, trial balance, and income statement; and (6) information about any threatened, pending, or settled litigation or arbitration involving the adviser or any of its supervised persons.
- Demographic and other specific data regarding each advisory client account, including information about: (1) advisory services provided, such as portfolio management, financial planning, and/or bundled wrap fee arrangements; (2) types of client accounts serviced, such as individual, defined benefit retirement plan, registered fund, or private fund; (3) advisory authority to trade in the account, such as whether it has discretionary authority; (4) advisory personnel servicing and overseeing the account; (5) assets under management advised by the firm; (6) third-party service providers, such as custodians, administrators, and auditors; and (7) investment strategies, such as global equity, high-yield, aggressive growth, long-short, or statistical arbitrage. In addition, the staff often requests documents supporting the adviser’s representations, such as copies of select contracts, agreements, or third-party account statements.
- Information regarding the adviser’s compliance program, risk management practices and framework, and internal controls, including written compliance policies and procedures and the adviser’s code of ethics.
- Information to facilitate the staff testing for regulatory compliance in certain areas, including portfolio management and trading activities, such as a record of specific information for all advisory clients’ securities holdings and transactions.
- Communication used by the adviser to inform or solicit new and existing clients, including disclosure documents and advertising, such as pamphlets, social media, mass mailings, websites, and blogs.
- Staff Observations From Recent Newly-Registered Adviser Examinations
The staff’s review of recent newly-registered adviser examinations identified issues in the following three areas, among others: (1) compliance policies and procedures; (2) disclosure documents and filings; and (3) marketing.
- Compliance Policies and Procedures. The staff observed compliance policies and procedures that: (1) did not adequately address certain risk areas applicable to the firm, such as portfolio management and fee billing; (2) omitted procedures to enforce stated policies, such as stating the advisers’ policy is to seek best execution, but not having any procedures to evaluate periodically and systematically the execution quality of the broker-dealers executing their clients’ transactions; and/or (3) were not followed by advisory personnel, typically because the personnel were not aware of the policies or procedures or the policies or procedures were not consistent with their businesses or operations. Additionally, the staff observed advisers’ annual compliance reviews that did not address the adequacy of the advisers’ policies and procedures and the effectiveness of their implementation. For example, the staff observed advisers that:
- Used off-the-shelf compliance manuals that were not tailored for consistency with the advisers’ operations and business lines.
- May not have devoted sufficient resources to comply with regulatory requirements and their own policies and procedures (e.g., advisers may have assigned additional and unrelated responsibilities to the chief compliance officer (“CCO”), resulting in limited time for the CCO to dedicate to compliance), or to ensure compliance personnel understood actual business practices.
- Had undisclosed conflicts of interest created by the multiple roles and responsibilities of advisory personnel carrying out the assigned duties, and these conflicts were not mitigated.
- Outsourced certain business and compliance functions without assessing how these outsourced responsibilities were being performed or whether they were consistent with the advisers’ compliance policies and procedures.
- Did not have adequate business continuity plans, including succession plans.
- Disclosure Documents and Filings. The staff observed required disclosure documents that contained omissions or inaccurate information and untimely filings (i.e., material or annual form updates were not made within prescribed timeframes or at all). The disclosure omissions and inaccuracies were related to advisers’: (1) fees and compensation; (2) business or operations (including affiliates, other relationships, number of clients, and assets under management); (3) services offered to clients, such as disclosure regarding advisers’ investment strategy (including the use of models), aggregate trading, and account reviews; (4) disciplinary information; (5) websites and social media accounts; and (6) conflicts of interest.
- Marketing. The staff observed adviser marketing materials that appeared to contain false or misleading information, including inaccurate information about advisory personnel professional experience or credentials, third-party rankings, and performance. Advisers were also unable to substantiate certain factual claims.
5. On March 23, 2023, the SEC charged Darryl Matthew Cohen, a former investment adviser at a large financial institution, with misappropriating more than $1 million from three current and former NBA players over a period of two and a half years. Cohen used client funds, without their understanding or authorization, for personal expenditures including to support his son’s amateur basketball program, for a home gym, and to pay back another client whose funds Cohen had misappropriated. Cohen also allegedly sold life insurance settlements to the clients for kickbacks to fund his home improvements. The matter is being litigated. https://www.sec.gov/litigation/litreleases/2023/lr25672.htm
6. On March 23, 2023, the SEC entered a final consent judgment against Martin Silver, the co-founder of International Investment Group (IIG), a formerly registered investment adviser, enjoining him from violating the antifraud provisions of the federal securities laws. Silver, defrauded IIG’s investment advisory clients by, among other things, grossly overvaluing the assets in IIG’s flagship hedge fund. The overvaluation of these assets resulted in the fund paying inflated fees to IIG, some of which went to Silver. Silver falsely reported to investors that certain fake and overvalued loan assets, which IIG sold between funds it advised, were legitimate assets and fairly valued. The matter is being litigated. https://www.sec.gov/litigation/litreleases/2021/lr25070.htm
7. On March 20, 2023, the SEC’s Office of Municipal Securities announced that it updated its Registration of Municipal Advisors Frequently Asked Questions webpage to add a section, entitled Completion of Form MA, Form MA-I, and Form MA-NR, which provides additional staff guidance on the required information and timelines regarding:
- Form MA, for an application for municipal advisor registration, annual update of municipal advisor registration, and an amendment of a prior application for registration;
- Form MA-I, for information regarding natural persons who engage in municipal advisor activities; and
- Form MA-NR, for designation of U.S. agent for service of process for non-residents.
Additional information can be found here: https://www.sec.gov/info/municipal/mun-advisors-faqs
8. On March 17, 2023, the SEC announced charges against Massachusetts-based investment adviser Jeffrey Cutter and his advisory firm, Cutter Financial Group LLC (“CFG”), for recommending that their advisory clients invest in insurance products that paid Cutter a substantial up-front commission without adequately disclosing Cutter’s and CFG’s financial incentive to sell the products. Cutter also made false statements in applications for the insurance products and made false statements to at least one client regarding his commission compensation. Cutter sold investment advisory clients certain insurance products, called fixed index annuities, without adequately disclosing Cutter’s and CFG’s financial incentive to recommend fixed index annuities over other investment options. Cutter received through CFG an annual asset-based advisory fee of approximately 1.5% to 2% on assets managed in a client’s advisory account, Cutter received up-front commissions on annuity sales of approximately 7% of the annuity’s total value. Cutter failed to disclose to clients the amount or up-front nature of the annuity commissions, or how the annuity commissions compared to the asset-based annual advisory fees he received on assets in advisory accounts, in violation of Cutter’s and CFG’s fiduciary duty. Cutter recommended some clients surrender a fixed index annuity the client already owned, including fixed index annuities he sold the client previously, and use the funds to purchase a new fixed index annuity through Cutter, which generated a second up-front commission and sometimes caused clients to incur surrender charges, without adequately disclosing his and CFG’s conflict of interest. Cutter also misrepresented certain clients’ financial circumstances in annuity applications to insurance companies to help ensure the applications would be approved by the insurance carrier and misrepresented to at least one client the percentage of commissions he would earn on the client’s fixed index annuity purchases. Cutter and CFG also failed to disclose the receipt of over $148,000 of free marketing services from a field marketing organization that provided Cutter and CFG with annuity sales support. This matter is being litigated. https://www.sec.gov/litigation/litreleases/2023/lr25669.htm
9. On March 6, 2023, the SEC filed an emergency action in which it successfully obtained an asset freeze, appointment of a receiver, and other emergency relief against Miami-based investment adviser BKCoin Management LLC and one of its principals, Kevin Kang, in connection with a crypto asset fraud scheme. BKCoin raised approximately $100 million from at least 55 investors to invest in crypto assets, but BKCoin and Kang instead used some of the money to make Ponzi-like payments and for personal use. BKCoin and Kang assured investors that their money would be used primarily to trade crypto assets and represented that BKCoin would generate returns for investors through separately managed accounts and five private funds. BKCoin and Kang disregarded the structure of the funds, commingled investor assets, and used more than $3.6 million to make Ponzi-like payments to fund investors. Kang misappropriated at least $371,000 of investor money to, among other things, pay for vacations, sporting events tickets, and a New York City apartment. Kang attempted to conceal the unauthorized use of investor money by providing altered documents with inflated bank account balances to the third-party administrator for certain of the funds. BKCoin materially misrepresented to some investors that BKCoin, or one of the funds, received an audit opinion from a “top four auditor,” when in fact neither BKCoin nor any of the funds received an audit opinion at any time. This matter is being litigated. https://www.sec.gov/litigation/litreleases/2023/lr25657.htm
10. On March 15, 2023, the SEC reopened the comment period on proposed rules and amendments related to cybersecurity risk management and cybersecurity-related disclosure for registered investment advisers, registered investment companies, and business development companies that were proposed by the Commission on February 9, 2022. The initial comment period ended on April 11, 2022. Tthe SEC proposed new Rule 206(4)-9 related to cybersecurity risk management for investment advisers as well as amendments to certain rules that govern investment adviser. The proposed rule is intended to address the SEC’s concerns for client and investor protection and transparency of information about cybersecurity incidents and would define a “cybersecurity risk” as the “financial, operational, legal, reputational, and other adverse consequences that could stem from cybersecurity incidents, threats, and vulnerabilities.
The proposed rule would require advisers to adopt and implement written cybersecurity policies and procedures designed to address cybersecurity risks that could harm advisory clients and investors. The proposed rule also would require advisers to report significant cybersecurity incidents affecting the adviser or private fund clients to the Commission on a new confidential form. To further help protect investors in connection with cybersecurity incidents, the proposal would require advisers and funds to publicly disclose cybersecurity risks and significant cybersecurity incidents that occurred in the last two fiscal years in their SEC Form ADV. Additionally, the proposal would set forth new recordkeeping requirements for advisers and funds that are designed to improve the availability of cybersecurity-related information and help facilitate the Commission’s inspection and enforcement capabilities.
In sum, the proposed rule would require:
- Policies and Procedures – Advisers would be required to adopt and implement written policies and procedures, including specific enumerated elements, reasonably designed to address cybersecurity risks.
- Reporting – Advisers to report certain cybersecurity incidents to the SEC on new Form ADV-C within 48 hours, including on behalf of any registered funds or private funds that experience such incidents; and
- Disclosure – Advisers to disclose cybersecurity risks and incidents in their SEC Form ADV.
In addition, the SEC proposed corresponding amendments to certain recordkeeping rules that would obligate advisers to maintain for five years copies of cybersecurity policies, reports of annual reviews, Form ADV-C filings, incident records, and risk assessments.
11. On March 3, 2023, the SEC charged Silver Edge Financial LLC (SEF), Equity Acquisition Company Ltd. (EAC), the owners of both companies, and sales staff of SEF with unregistered broker-dealer activity relating to their sales of interests in shares of various pre-IPO companies. SEF, its owner Daniel Mackle, Sr., and six salespeople sold interests in two funds that were set up as series LLCs, with each series representing an interest in shares of a single pre-IPO company. The underlying assets in these series were interests in shares of companies that were expected to undertake an initial public offering or other liquidity event within two-to-five years. SEF, Mackle, and the salespeople solicited accredited investors and raised more than $65 million while failing to register as brokers with the Commission, as required. EAC and its founder, Carsten Klein, acted as unregistered dealers in connection with their business of obtaining pre-IPO shares and offering them for sale to various pre-IPO funds, including the Silver Edge funds. EAC purchased more than 14 million shares of pre-IPO companies, including a number of highly-anticipated offerings, and sold more than $13.4 million in shares to various pre-IPO funds, while keeping the remaining shares in inventory. SEF and Mackle agreed to pay disgorgement and prejudgment interest of more than $2.5 million and a civil penalty of $975,000, and they agreed to industry and penny stock bars with the right to reapply after five years. EAC and Klein agreed to pay disgorgement and prejudgment interest of more than $3.6 million and a civil penalty of $269,360. SEF, Mackle, EAC, and Klein also agreed to undertakings that will help ensure the legal and orderly distribution of pre-IPO interests. The six salespeople – Scott Esposito, Richard Konopka, Robert Daniel Louis, Dave Nicolas, Joshua Simmons, and Daniel Esposito – agreed to pay civil penalties ranging from $61,000 to $124,320 and to industry and penny stock bars. https://www.sec.gov/news/press-release/2023-44
12. On March 3, 2023, the SEC charged New York-area twin brothers, Adam Kaplan and Daniel Kaplan, for engaging in several different fraudulent activities to misappropriate more than $5 million from at least 60 of their investment advisory clients. The Kaplans were associated as investment adviser representatives with an SEC-registered investment adviser from May 2018 until their termination in July 2021, and after leaving that firm, they continued to act as investment advisers to certain clients. The Kaplans overcharged clients for advisory fees by fraudulently inflating the fee amounts in clients’ advisory agreements, without the clients’ knowledge or consent, so that they could collect higher fees than their clients had agreed to pay. The Kaplans misappropriated clients’ funds by fraudulently applying charges to their clients’ credit card and bank accounts for, among other things, purported investments or additional advisory fees to which the Kaplans were not entitled. The Kaplans used the clients’ funds obtained from these fraudulent activities for their personal benefit and to repay certain clients who complained about unusual account activity. The Kaplans falsified documents and made Ponzi-like payments to clients to conceal their fraudulent activities. This matter is being litigated. https://www.sec.gov/litigation/litreleases/2023/lr25656.htm
13. On March 2, 2023, the SEC filed fraud charges against the father and son financial advisory team of Kevin Kane and Sean Kane of York, Pennsylvania. Kanes were terminated for cause from a dually-registered investment adviser and broker-dealer for multiple violations of the firm’s policies and procedures. Following their terminations, in an effort to convince certain of their clients to join them at a new firm, the Kanes falsely represented to clients that they left their former firm voluntarily. The Kanes also misrepresented to certain clients that they were still associated with their former firm and could still access client accounts. To further their deceit, the Kanes impersonated certain clients in phone calls to their former firm in order to execute transactions in their clients’ accounts. This matter is being litigated. https://www.sec.gov/litigation/litreleases/2023/lr25655.htm
14. On March 2, 2023, the SEC instituted administrative proceedings against Cambria Capital, LLC. Cambria Capital, LLC., a dually registered investment adviser and broker-dealer, failed to file Suspicious Activity Reports (“SARs”) with the U.S. Treasury Department’s Financial Crimes Enforcement Network (“FinCEN”) when it knew, suspected, or had reason to suspect that the transactions facilitated fraudulent activity or had no legitimate business basis or apparent lawful purpose. Cambria was a broker-dealer that specialized in helping its customers liquidate microcap securities. Numerous transactions by Cambria customers raised “red flags” that indicated customers may have been involved in suspicious activities. Most of these suspicious activities were associated with the liquidation of microcap securities, including the deposit of physical certificates, the liquidation of large quantities of these securities, and the immediate wire out of funds from customer accounts. The pattern of liquidations often occurred in combination with other red flags noted in Cambria’s policies and procedures, such as unusually large deposits, suspicious wire activity, or multiple accounts simultaneously trading in the same microcap security. Cambria failed to investigate its customers’ suspicious trading and similarly failed to file SARs for many of the transactions even though Cambria’s WSPs identified such activity as risk indicators (red flags) of suspicious activity, and required further investigation for the possible filing of a SAR. Cambria’s business focus on the liquidation of microcap securities and the existence of numerous red flags, Cambria has no record of investigating any suspicious activity and filed only two SARs. Cambria Capital was ordered to pay a civil penalty of $100,000. https://www.sec.gov/litigation/admin/2023/34-97020.pdf
14. On March 1, 2023, the SEC charged Stephen Woodard, Sr., an unregistered investment adviser, with running a Ponzi scheme in which he offered and sold securities to more than two dozen victims, many of whom he solicited through his church. Woodard raised approximately $6 million from about 30 purchasers of promissory notes issued by Morganwood Ltd., an entity he controlled. Woodard told investors, some of whom were also his investment advisory clients, that he employed a risk-free trading strategy that focused on the preservation of capital but still yielded impressive returns. Woodard invested only a small amount of investor capital, made increasingly risky bets on the market, and sustained heavy losses. Woodard used the majority of investor monies to pay investors phantom returns on their investments, and that instead of disclosing his mounting trading losses, Woodard provided his investors with false account statements showing illusory gains in the value of their investments. This matter is being litigated. https://www.sec.gov/litigation/litreleases/2023/lr25654.htm
15. On March 1, 2023, the SEC charged Ryan Riley an investment adviser with defrauding investors and other advisory clients out of nearly half a million dollars. Riley, of Leesburg, Virginia, solicited advisory clients and other individuals to invest in securities issued by his companies, Green Light Energy, LLC and Mustang Resources, Inc. Riley induced investors to invest by claiming that he would use their funds to acquire, develop, and operate oil & gas drilling projects in Texas. Riley misappropriated the funds, using some for personal expenses and losing the majority through risky day trading. This matter is being litigated. https://www.sec.gov/litigation/litreleases/2023/lr25653.htm
16. On March 1, 2023, the SEC instituted administrative proceedings against Brian Doherty. Doherty was a registered representative associated with BGC Financial L.P. (“BGC”), a broker-dealer registered with the Commission. Doherty was discharged by BGC for participating in improperly prearranged intra-day trading transactions. Doherty was subsequently a registered representative of another broker-dealer firm. Doherty was charged engaging in a fraudulent, prearranged trading scheme at BGC. Doherty willfully violated Section 10(b) of the Exchange Act, Exchange Act Rule 10b-5 and FINRA Rules by engaging in a fraudulent, prearranged trading scheme. Doherty was barred. https://www.sec.gov/litigation/admin/2023/34-96999.pdf
February was a busy month. In case you missed it, here are two noteworthy regulatory matters:
1. On February 27, 2023, two SEC Commissioners dissented from the finding in a settlement order against Huntleigh Advisors, Inc. and Datatex Investment Services, Inc. (together, the “Advisers”) in connection with charges that they breached their duty to seek best execution “by causing certain advisory clients to invest in fund share classes that charged 12b-1 fees when share classes of the same funds were available to the clients that presented a more favorable value under the particular circumstances in place at the time of the transactions.” https://www.sec.gov/news/statement/peirce-uyeda-statement-huntleigh-datatex-022723
2. On February 15, 2023, the SEC proposed sweeping revisions to the rule under the Investment Advisers Act of 1940, as amended (the Advisers Act) that addresses custody of client assets by registered investment advisers. If adopted as proposed, the rule will affect safeguarding of client assets, including digital assets, real estate, loans, and other emerging asset classes as well as physical assets. As proposed, the new rule also would affect the services offered by qualified custodians to advisers.
The proposed amendments to the Custody Rule would expand the scope beyond client funds and securities to include all client assets of which an advisor has custody, as well as include discretionary authority for the advisor to trade client assets in the definition of ‘custody’.
New Rule 223-1 (the Proposed Rule) would amend and redesignate Rule 206(4)-2, the current custody rule. The Proposed Rule would, among other things,
- expand the custody rule to apply to all client assets held in advisory accounts, not just client “funds and securities,” and explicitly include crypto assets (regardless of whether they are funds or securities);
- require advisers with custody of client assets to maintain them with a qualified custodian. To meet the “maintain” standard, the qualified custodian must have “possession or control” of client assets and must participate in any change of beneficial ownership of the client’s assets;
- require advisers to enter into written agreements with qualified custodians and obtain “reasonable assurances” concerning nine enumerated provisions that address safeguarding of client assets, including a requirement that the qualified custodian indemnify the client for losses resulting from the custodian’s own negligence;
- require qualified custodians to maintain client assets in bankruptcy-remote accounts that are clearly identified and segregated from the adviser’s proprietary assets;
- revise the exception for “privately offered securities” and create a new exception from the requirement to maintain certain assets with a qualified custodian, provided that the adviser meets certain conditions; and
- explicitly include in the definition of custody an adviser’s discretionary authority to trade client assets. The Proposed Rule, however, would exempt assets for which an adviser has custody from the surprise audit requirement if the adviser’s sole basis for being deemed to have custody is the adviser’s discretionary authority that is limited to instructing the client’s qualified custodian to transact in assets that settle on a delivery-versus-payment basis.
The Proposed Rule would apply to all registered investment advisers (and advisers required to be registered) under the Advisers Act. Exempt Reporting Advisers (ERAs, both U.S. and non-U.S.) and the accounts of the non-US clients of registered offshore advisers, however, would continue to fall outside of the scope of Advisers Act custody rules. Registered investment companies also would not be required to comply with the Proposed Rule, as they are subject to separate custody requirements under the Investment Company Act of 1940.
Our Compliance Analysis. The Proposed Rule will introduce new challenges to advisers and qualified custodians, especially with respect to custody of digital assets.
Application of the rule: what is custody of client assets? The Proposed Rule generally would preserve the current rule’s definition of “custody.” That is, the Proposed Rule would apply when an adviser “holds, directly or indirectly, client assets, or has any authority to obtain possession of them.” In other words, the Proposed Rule would apply when an adviser has the ability or authority to access, control, or effect a change in beneficial ownership of a client’s assets.
Like the current custody rule, the Proposed Rule would define three categories that serve as examples of custody:
- physical possession of an asset;
- any arrangement (including a general power of attorney or discretionary authority) that authorizes or permits the adviser to instruct the client’s custodian to withdraw client assets; and
- any capacity that gives the adviser or affiliate legal ownership or access to securities (e.g., a general partner of a limited partnership).
The Proposed Rule specifically includes “discretionary authority” within the definition of custody. An adviser would also continue to be deemed to have custody of client assets if it is authorized to withdraw funds from client accounts to pay its advisory fee.
Scope of assets covered. The current rule applies only to “funds and securities” held in a client’s account of which the adviser has custody. The Proposed Rule would expand the definition of assets to all assets within the scope of an adviser’s fiduciary relationship with its client, including:
- crypto assets, commodities, and other real assets;
- assets not typically included on a balance sheet for accounting purposes, such as short positions and written options;2
- derivatives contracts held for investment purposes, such as swaps; and
- physical assets, including artwork, real estate, precious metals, and physical commodities, such as wheat, lumber and whisky.
Definition of a qualified custodian. In a departure from the current rule, institutions may serve as qualified custodians only if they have “possession or control” of client assets pursuant to a written agreement between the qualified custodian and the investment adviser.
Written contract. The Proposed Rule requires a qualified custodian to maintain possession or control of client assets pursuant to a written agreement between the adviser and the qualified custodian. The written agreement must contain at least four enumerated safeguards that the Commission believes are “critical to safeguarding client assets” and that the adviser must “reasonably believe” have been implemented. This requirement generally formalizes requirements under the existing rule, except as noted. Specifically, at a minimum, the written agreement must provide that the qualified custodian:
- promptly, upon request, provide records to the Commission or to an independent auditor conducting an annual audit;
- send an account statement to the client or its representative identifying each client asset held in the account and summarizing all transactions;
- at least annually, provide the adviser with a written internal control report (the current requirement requires an internal control report only when the adviser or its related person acts as the qualified custodian); and
- specify the adviser’s agreed-on authority to effect transactions in the custody account and any relevant limitations (designed to distinguish between broad authority permitted in custody agreements as compared to more limited authority in advisory agreements).
The Proposed Rule would require the adviser to obtain from each qualified custodian “reasonable assurances,” in writing, that the qualified custodian will provide certain client enumerated safeguards. Specifically:
- Standard of Care. The qualified custodian will exercise due care in accordance with reasonable standards in discharging its custodial duties and will implement appropriate measures to safeguard client assets;
- Indemnification. The qualified custodian will indemnify the client (and will have insurance arrangements in place that will adequately protect the client, which may be difficult to obtain for certain asset classes, such as crypto assets) against the risk of loss of the client’s assets maintained with the qualified custodian in the event of the qualified custodian’s negligence, recklessness, or willful misconduct;
- Sub-custody. The existence of any sub-custodial, securities depository or other similar arrangements with regard to client’s assets will not excuse any of the qualified custodian’s obligations to the client;
- Segregation of Client Assets. The qualified custodian will hold client assets in a custodial account, segregated from the qualified custodian’s proprietary assets and liabilities; and
- No Security Interest or Lien. The qualified custodian will not subject client assets to any right, charge, security interest, lien, or claim in favor of the qualified custodian or its related persons or creditors, except as agreed to by the client.
Assets unable to be maintained by a qualified custodian. The Commission acknowledged that some assets – particularly physical assets and certain privately offered securities – may be difficult or impossible to maintain at a qualified custodian. The Proposed Rule provides an exception to the requirement to maintain client assets with a qualified custodian when an adviser has custody of privately offered securities or physical assets, provided that:
- the adviser reasonably determines and documents in writing that ownership cannot be recorded and maintained (book entry, digital, or otherwise) in a manner in which a qualified custodian can maintain possession or control transfers of beneficial ownership of such assets; and
- the adviser reasonably safeguards the assets from loss, theft, misuse, misappropriation, or the adviser’s financial reversals, including the adviser’s insolvency.
In addition, to rely on this exception, the adviser must enter into a written agreement with an independent public accountant and notify that accountant of any purchase, sale or transfer of beneficial ownership of any asset within one business day. The agreement would require the independent public accountant to notify the Commission within one business day of finding any discrepancies. In a departure from the current rule, each privately offered security or physical asset not maintained with a qualified custodian would have to be verified in either a surprise examination or audit.
Possession or control of client assets. In a change from the current rule, a custodian would be permitted to serve as a qualified custodian only if it has “possession or control” of client assets pursuant to a written contract with the adviser. Possession or control of client assets would depend, in part, on whether the qualified custodian is required to participate in a change in the beneficial ownership of a particular asset, and the qualified custodian’s involvement is a condition precedent to the change in beneficial ownership. (In the Release, the Commission acknowledges that other functional regulators have not defined “possession or control” in the custody context in exactly the same manner. The Commission said that, nonetheless, the proposed rule’s definition is designed to be consistent with the rules of other functional regulators that apply to the qualified custodians that they regulate, such as a broker-dealer’s possession and control requirements contained in Rule 15c3-3 under the Securities Exchange Act of 1934.)
The “possession or control” standard could affect broad categories of market participants who facilitate transactions in nontraditional assets—including, for example, floating rate and other loans and certain derivatives—when third parties effect a transfer of ownership or collect interest payments. The Proposed Rule, however, appears to target, among other things, crypto trading platforms that require investors to transfer digital assets and fiat currency to the exchange prior to executing a trade (see “Implications for all digital asset market participants” below). The Commission stated that these arrangements “would generally result in an adviser with custody of a crypto asset security” in violation of the Proposed Rule, because the asset is not maintained by a qualified custodian.
Discretionary authority. The Proposed Rule would explicitly identify an adviser’s discretionary trading authority as an arrangement that would trigger the application of the custody requirements. As such, the adviser would be subject to the requirement that client assets must be verified by an actual examination at least once during each calendar year by an independent public accountant (the so-called “surprise examination” requirement).
The Proposed Rule, however, would exempt advisers from the surprise audit requirement for certain assets under limited circumstances. For example, the exemption would apply when an adviser is deemed to have custody of client assets solely as a consequence of its authority to withdraw funds from client accounts to pay its advisory fee. Also, the exemption would apply when the sole basis for the adviser’s custody is discretionary authority with respect to those assets, and only with respect to “DVP,” or delivery-versus-payment, settled transactions (that is, the adviser’s authority is limited to authorizing a custodian to transfer securities out of a client’s account upon receipt of a corresponding transfer of assets into the account). On the other hand, in the case of assets settled on a basis other than DVP, advisers would be subject to the surprise audit requirements of the Proposed Rule.
Amendment to recordkeeping rule (Advisers Act Rule 204-2). The Proposed Rule would add new recordkeeping requirements, including, among others:
- retaining copies of required client notices;
- creating and retaining records and documenting certain client account information, including copies of all account opening records and whether the adviser has discretionary authority;
- creating and retaining records of certain custodian information, including required qualified custodian agreements and written assurances obtained from the qualified custodian;
- creating and retaining a record that indicates the basis of the adviser’s custody of client assets;
- retaining copies of all account statements;
- retaining copies of any standing letters of authorization; and
- keeping records relating to engagement of independent accountants.
Form ADV amendments. The Proposed Rule updates related recordkeeping requirements for advisers and amends Form ADV with respect to custody-related data available to the Commission, its staff and the public. The proposed new reporting requirements in Item 9 include additional details addressing the basis of custody of client assets, qualified custodians that maintain clients assets, and independent public accountants that have been engaged to provide either surprise examinations or financial statement audits of private funds.
Status of state-chartered trust companies and limited purposes banks. As mentioned above, the Proposed Rule would not change the types of financial institutions eligible to act as qualified custodians—which include “banks” (as defined in Section 202(a)(2) of the Advisers Act). The Proposed Rule, however, would require advisers to contract directly with, and obtain reasonable assurances from, qualified custodians relating to “minimum custodial protections” for client assets.
Implications for all digital asset market participants. The Release extensively discusses crypto assets (also referred to as digital assets), and the potential implications for advisers that transact in crypto assets could be significant.
- Crypto assets are in scope. First, the Release includes a policy statement, echoing public statements made by Chair Gary Gensler, that many (with very few exceptions) crypto assets are securities. The Release states that advisers asserting the Proposed Rule would not apply to crypto assets are incorrect “because most crypto assets are likely to be funds or crypto asset securities covered by the current rule.”
In a footnote, the Release attempts to clarify this point further and suggests that even crypto assets that are not securities would be considered “funds” within the scope of the current rule, but it does not elaborate or analyze why crypto assets would be considered “funds,” as opposed to other types of property. By expanding the scope of regulation to include all assets within the scope of a registered adviser’s fiduciary relationship with its client, the Proposed Rule would remove any doubts that it would apply to crypto assets.
- Possession or control of crypto assets. The Release notes that the requirement for qualified custodians to obtain and maintain “possession or control” of client assets may present unique challenges for crypto assets. The Release acknowledges that while it is possible for a custodian to implement processes that seek to create exclusive possession of control of crypto assets, it may be difficult to actually demonstrate that it has exclusive possession or control due to their specific characteristics (e.g., anyone with possession of the private key can transfer ownership of the asset).
Recognizing the difficulty for a custodian to prove that it has exclusive control over the private keys necessary to control crypto assets, the Release does not view exclusive possession or control as the only way a custodian could demonstrate it meets the definition of the “possession or control.” The definition of “possession or control” in the Proposed Rule provides flexibility by permitting for situations when the custodian is necessary to change the beneficial ownership of the asset, even if it could not affect the change in ownership acting alone. For example, “a qualified custodian would have possession or control of a crypto asset if it generates and maintains private keys for the wallets holding advisory client crypto assets in a manner such that the adviser is unable to change beneficial ownership of the crypto asset without the custodian’s involvement.”5 These arrangements may include multisignature, or “multisig,” technology solutions for crypto asset custody, among others.
The Release does not address how the functional regulators of different types of qualified custodians define possession or control—even when the functional regulator is the Commission, although the Release specifically cites the Special Purpose Broker-Dealer Custody Statement as applicable guidance for broker-dealers that intend to custody crypto asset securities.
- Crypto asset trading platforms. The Release notes that the requirement for a qualified custodian to maintain possession or control of client assets at all times when the investment adviser has custody means that advisers who trade on crypto asset platforms that require prefunding the platform would generally be in violation of both the current custody rule and Proposed Rule if the trading platform does not satisfy the definition of a qualified custodian. Interestingly, the Release notes that while the majority of crypto asset trading occurs on platforms requiring prefunding of trades, some trading of crypto assets occurs on a noncustodial basis through decentralized platforms and Alternative Trading Systems (ATSs).
- Status of crypto as “privately offered” securities. In the context of “privately offered securities” exception, the Release states that, as a result of “transactions and ownership involving crypto asset securities on public, permissionless blockchains [being] generally evidenced through public keys or wallet addresses,” the staff believes “that such crypto asset securities issued on public, permissionless blockchains would not satisfy the conditions of the privately offered securities” because under the Proposed Rule, for a security to be a “privately offered security,” it must be “uncertificated, and the ownership can only be recorded on the non-public books of the issuer or its transfer agent in the name of the client as it appears in the adviser’s required records. (Emphasis added.)7
Compliance transition. The Proposed Rule requires compliance within one year following the rule’s effective date for advisers with more than US$1 billion in regulatory assets under management (RAUM), and 18 months for advisers with less than US$1 billion in RAUM.