The growing fascination with digital assets, including cryptocurrencies and tokens, presents legal and operational challenges to investors, entrepreneurs and service providers, not to mention the regulators who oversee them. Perhaps no cryptocurrency issue presents more challenges than custody: how do individuals, broker-dealers, investment advisers, private funds and registered investment companies legally and effectively safeguard digital assets?
On the surface, the answer is simple: individuals can store their cryptocurrencies in digital wallets. Private funds managed by registered investment advisers can store their cryptocurrencies with "qualified custodians." Registered investment companies can store their cryptocurrencies only with custodians that meet additional statutory requirements.1
But alas, as is often the case with digital assets, it is not so simple. In reality, the operational and regulatory issues are more complicated, including whether the custody arrangements meet regulatory requirements, and whether they provide adequate safeguards, regardless of regulatory requirements.
This chapter examines the custody requirements that apply to various industry players under U.S. investment management laws and regulations, and analyses the challenges that they and the regulators face in evaluating arrangements for safeguarding digital assets.2
Before we examine the legal requirements for custody, it is helpful to ensure that we use consistent terminology.
For the purposes of this chapter, "cryptocurrencies" refer to digital assets that function as a digital representation of a store of value, such as Bitcoin or Ethereum. Cryptocurrencies are not issued or backed by a central government, and thus are not legal tender. Alternatively we refer to cryptocurrencies as "digital currency" or "virtual currency."
"Utility tokens" refer to coins or tokens that serve a particular (non-incidental) function, or give the holder rights or access to goods, licences or services. A common form of utility token may give the holder the right to use a computer program that provides a kind of service for a defined period of time. Some refer to utility tokens as "app coins," "app tokens," or "utility coins." Some utility tokens may be securities, others are not. As we will see later, whether or not a utility token is characterised as a security becomes critical in evaluating what custody rules apply.
"Securities tokens" or "investment tokens" are tokens or coins that are securities for purposes of federal securities laws. The status of a token as a security token may be intentional or unintentional. Some utility tokens may start out as securities and at some point morph into non-securities, depending on their usage, how they are sold, and the expectations of the holders of those tokens.
Simply labelling a digital asset as a utility token, however, does not mean that the digital asset is not a security.3 The analysis of whether or not a utility token functions as a security token, or when a security token transforms into a utility token is beyond the scope of this chapter, but, again, the distinction is relevant for purposes of the custody analysis.
Legal requirements for custody of digital assets
The safeguarding of client assets has long been a priority of Congress and the Securities and Exchange Commission (the SEC). The legislative history of the Investment Company Act of 1940 (the ICA), and, by implication, its companion statute, the Investment Advisers Act of 1940 (the Advisers Act), shows that Congress was clearly concerned with the potential for abuses or misappropriation of client assets held in investment trusts and managed by investment advisers:4
That investors in investment trusts and investment companies are subject to substantial losses at the hands of unscrupulous persons is obvious from the very nature of the assets of such companies. Their assets consist almost invariably of cash and marketable securities. They are liquid, mobile, and easily negotiable. These assets can be easily misappropriated, 'looted,' or otherwise misused for the selfish purposes of those in control of these enterprises. In the absence of regulating legislation, individuals who lack integrity will continue to be attracted by the opportunity available for personal profit in the control of the liquid assets of investment trusts and investment companies.5
The Senate had similar concerns:
Basically the problems fl ow from the very nature of the assets of investment companies. The assets of such companies invariably consist of cash and securities, assets which are completely liquid, mobile and readily negotiable. Because of these characteristics, control of such funds offers manifold opportunities for exploitation by the unscrupulous managements of some companies. These assets can and have been easily misappropriated and diverted by such types of managements, and have been employed to foster their personal interests rather than the interests of public security holders. It is obvious that in the absence of regulatory legislation, individuals who lack integrity will continue to be attracted by the opportunities for personal profit available in the control of the liquid assets of investment companies and that deficiencies which have occurred in the past will continue to occur in the future.6
These issues made national headlines in December 2008, when Bernard L. Madoff admitted to perpetrating a massive Ponzi scheme in which he convinced his clients that they owned securities that did not exist. For years, he evaded regulatory scrutiny until the scheme began to unravel. This scandal prompted the SEC to take actions to reduce the chance that a Madoff-style fraud would occur or go undetected in the future.7 While the SEC took steps to bolster its oversight and enforcement functions, it focused on rules designed to enhance the custody rules for investment advisers and broker-dealers. In December 2009, the SEC amended Rule 206(4)-2 (the "custody rule"), which was designed to provide greater assurance that investors' accounts contain the funds that their account statements say they contain.
Among other things, the rule encouraged advisers to maintain their clients' assets with independent custodians. For investment advisers who can control their clients' assets, the rules require enhanced procedures, such as surprise asset-counts, third-party reviews and audited financial statements. To be sure, when the U.S. Congress enacted the ICA and the Advisers Act, it clearly did not contemplate, or could even dream of, how the law would apply to digital assets such as cryptocurrencies or utility tokens. But the basic concerns of preventing fraud or misappropriation are just as valid today as they were in 1940. The only difference, of course, is that we are now attempting to apply 80-year-old laws designed to protect assets consisting of cash and securities to an entirely new class of digital assets created by a technology that did not exist at the time the laws were written.
What is "custody"?
Rule 206(4)-2 under the Advisers Act defines custody to mean "holding, directly or indirectly, client funds or securities, or having any authority to obtain possession of them." The regulation provides that you have custody of an asset "if a related person holds, directly or indirectly, client funds or securities, or has any authority to obtain possession of them, in connection with advisory services you provide to clients."
Rule 206-4(2) defines custody of an asset to include:
- possession of client funds or securities;
- any arrangement (including a general power of attorney) under which you are authorised or permitted to withdraw client funds or securities maintained with a custodian upon your instruction to the custodian; and
- any capacity (such as general partner of a limited partnership, managing member of a limited liability company or a comparable position for another type of pooled investment vehicle, or trustee of a trust) that gives you or your supervised person legal ownership of or access to client funds or securities.
A threshold question is whether the SEC's custody rule applies to digital assets? The answer depends on the facts and circumstances.
The SEC's Division of Investment Management has said that Rule 206(4)-2 does not apply to an adviser to the extent that it manages assets that are "not funds or securities."8 Does this mean that advisers to clients or funds that invest in Bitcoin are free to hold these assets in personal digital "wallets" without regard to federal regulation? If not, to what standard will an adviser be held? Again, it depends. In light of the legislative history, which makes the protection of investors' assets a priority, it is possible that most, if not all, digital assets would be considered "funds or securities" for the purposes of the Advisers Act and the custody rule. The matter is not free from doubt.
What are the legal custody requirements for an investment adviser?
The first step in analysing the legal requirements for the custody of assets is to determine the nature of the investment adviser. The two threshold questions are:
- What law applies? That is, is the adviser an "investment adviser" as defined in the Investment Advisers Act of 1940, as amended (the "Advisers Act")?
- If yes, is the adviser registered or required to be registered under the Advisers Act?
Next, we examine the nature of the assets and the nature of the entity that holds them.
What law applies?
To determine what law applies, we must look at the nature of the person or entity that holds or proposes to hold a digital asset. The holder of a digital asset can be:
- a natural person, directly or in a managed account;
- a pooled investment vehicle that is not publicly offered in the U.S., such as a hedge fund, private equity fund, or other private fund;
- a pooled vehicle that is registered as an investment company;
- a regulated entity such as a broker-dealer, bank or investment adviser;
- an operating company; or
- other pooled investment vehicles which might be commodity pools that otherwise would be investment companies but for an exemption under the 1940 Act.
Our focus here will be investment advisers and their clients, including natural persons, private funds and investment companies. We first discuss investment advisers and then registered investment companies.
Originally published by Global Legal Group, London.
1. Broker-dealers, commodity pool operators, commodity trading advisors and advisers to certain retirement plans are subject to separate requirements, which are not the subject of this chapter.
2. For a general discussion of blockchain issues for investment managers, see Jay G. Baris and Joshua Ashley Klayman, "Blockchain Basics for Investment Managers: A Token of Appreciation," 51 The Review of Securities and Commodities Regulation 67 (Mar. 21, 2018), available at https://www.shearman.com/-/media/Files/Perspectives/2018/03/Baris_Klayman_RSCR_Final_1.pdf?la=en&hash=4CD602B56ED60D38CB5EAC232EF3D80981026B0F.
3. William Hinman, Director SEC Division of Corporate Finance, Digital Asset Transactions: When Howey Met Gary (Plastic), Remarks at the Yahoo Finance All Markets Summit: Crypto (June 14, 2018), available at https://www.sec.gov/news/speech/speech-hinman-061418.
4. The Advisers Act does not specifically address custody of clients. Rather, the SEC addressed this issue in the Rule 206(4)-2 under the Advisers Act (the "custody rule"), which is discussed below.
5. H.R. Report No. 76-2639 (1940).
6. Senate Report No. 76-1744 (1940).
7. The Securities and Exchange Commission Post-Madoff Reforms, available at https://www.sec.gov/spotlight/secpostmadoffreforms.htm.
8. The SEC staff has taken the position that if an adviser manages client assets that are not funds or securities, the custody rule does not require the adviser to maintain the assets with a qualified custodian. Question II.3, Staff Responses to Questions About the Custody Rule (online FAQ), available at https://www.sec.gov/divisions/investment/custody_faq_030510.htm. The issue now presented is whether the SEC staff considers cryptocurrencies to be "funds or securities" for purposes of the custody rule.
The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.