On July 8, 2019, the SEC’s Division of Trading and Markets and FINRA’s Office of General Counsel issued a joint statement (the “Statement”) on the application of securities laws to digital asset securities. In summary, the Statement highlighted the following areas:
Customer Protection Rule Impact
A company that effects transactions in digital asset securities for its own account or the accounts of others must register as a broker-dealer under Section 15 of the Securities Exchange Act of 1934. In addition, these companies must meet the requirements of Rule 15c3-3 (the “Customer Protection Rule”) if they intend to custody digital asset securities.
The Customer Protection Rule requires broker-dealers to maintain customer securities free of liens at a good control location as defined under Rule 15c3-3(c). Generally, broker-dealers can custody customer securities at a third-party custodian. However, uncertificated securities such as private placements can be held at the issuer or at a transfer agent.
That said, the SEC and FINRA will consider whether the issuer or the transfer agent qualifies as an acceptable control location in accordance with the Customer Protection Rule, that is, a location where the issuer or a transfer agent maintains a traditional single master security holder list but also publishes the ownership record using distributed ledger technology as a courtesy.
Noncustodial Broker-Dealer Models for Digital Asset Securities
Broker-dealers that effect transactions in digital asset securities, but do not engage in custody functions, do not raise the same level of regulatory concern as those involved in custody functions. To clarify this distinction, the SEC and FINRA have provided the following three examples of noncustodial broker-dealer models for digital asset securities:
- Traditional private placement model – In this model, broker-dealers send trade details (e.g., identity of the parties and quantity of purchase) to the buyer and issuer of a digital asset security, but it is the issuer that settles the transaction with the buyer. This is done away from the broker-dealer.
- Over-the-counter (“OTC”) secondary transaction model – In this model, broker-dealers facilitate OTC secondary transactions in digital asset securities but do not take custody of or exercise control over these securities.
- Alternative trading system (“ATS”) model – In this model, broker-dealers operate an ATS to match buyers and sellers of digital asset securities. The trades are subsequently settled directly between the buyers and sellers, or the buyers and sellers give instructions to their respective custodians to settle the transactions.
Books and Records
The SEC and FINRA also discussed the challenges that broker-dealers face in evidencing the existence of digital asset securities in their regulatory books, records, and financial statements. More specifically, the Statement emphasized that broker-dealers could experience problems with such evidencing, and that these problems could create difficulty for the broker-dealer’s independent auditor regarding attesting to financial statement assertions.
Securities Investor Protection Act of 1970 (the “SIPA”)
The SIPA may not protect certain digital asset securities because it defines such securities narrowly compared to their broader definitions under the federal securities laws.
As a reminder, FINRA recently issued Regulatory Notice 19-24, in which it encourages firms to notify their FINRA Coordinator if they, or the firms’ associated persons or affiliates, engaged in or intend to engage, digital assets activities.
For More Information
For more information about the application of SEC’s guidance on digital asset securities, please your ACA consultant or Dee Stafford at 561-628-5288 or firstname.lastname@example.org.