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On July 8, 2019, the SEC and FINRA issued a joint statement, which underscores the importance of establishing custody solutions that meet the possession or control standards over customers’ digital asset securities, or digital securities, because brokerage firms can fail just like Bear Stearns and Lehman Brothers failed in 2008. The joint statement acknowledges the fact that federal securities laws, FINRA (Financial Industry Regulatory Authority) rules, and other bodies of laws do not neatly apply to digital securities and related innovative technologies. An entity that is a broker-dealer – that is – an entity that buys, sells, or otherwise transacts or is involved in effecting transactions in digital asset securities for customers, must comply with broker-dealer financial responsibility rules, including custodial requirements under Rule 15c3-3 under the Securities Exchange Act of 1934, which is known as the Customer Protection Rule.
The SEC (U.S. Securities and Exchange Commission) has a mandate to protect investors; maintain fair, orderly, and efficient markets; and facilitate capital formation. FINRA has a mandate to provide investor protection and promote market integrity. The Customer Protection Rule is one of the broker-dealer financial responsibility rules. The purpose of the Customer Protection Rule is to safeguard customer securities and funds held by a broker-dealer by requiring the broker-dealer to keep customer assets separate from broker-dealer assets, thus, increasing the likelihood that customers’ securities can be returned to them in the event of the broker-dealer’s failure.
Various unregistered entities that intend to engage in broker-dealer activities involving digital asset securities are seeking to register with the SEC and FINRA members are seeking to expand their businesses to include digital asset securities. Whether a security is paper or digital, the same fundamental elements of the broker-dealer financial responsibility rules apply. However, the Customer Protection Rule does not neatly apply when digital securities, digital wallets, and alternative trading systems are involved. The SEC and FINRA acknowledge that it may be challenging to comply with financial responsibility rules without putting in place significant technological enhancements and solutions unique to digital securities.
According to the SEC’s Framework for “Investment Contract” Analysis of Digital Assets, the U.S. Supreme Court’s Howey analysis applies to digital assets. The Howey analysis is a four-prong test that determines whether an “investment contract” exists.
The first prong of the Howey test is typically satisfied in an offer and sale of a digital asset because the digital asset is usually purchased in the form of fiat currency, another digital asset or another type of consideration. The lack of monetary consideration for digital assets, such as those distributed via a so-called “bounty program” does not mean that the investment of money prong is not satisfied.
The second prong of the Howey test is typically satisfied because the fortunes of digital asset purchasers have been linked to each other or to the success of the promoter’s efforts.
The third prong of the Howey test is typically satisfied when a purchaser has a reasonable expectation of profits. Some examples that meet the reasonable expectation of profits prong are 1) when the digital asset gives the holder rights to share the enterprise’s income or profits or to realize gain from capital appreciation of the digital asset, or 2) the digital asset is transferable or traded on or through a secondary market or platform, or is expected to be in the future.
The fourth prong of the Howey test is typically satisfied when a purchaser is reasonably expected to rely on the efforts of others and those efforts are the undeniably significant managerial efforts which affect the failure or success of the enterprise. A classic example that meets the “derived from the efforts of others” prong are when the network or the digital asset is still in development and the network or digital asset is not fully functional at the time of the offer or sale such that purchasers would reasonably expect others to further develop the functionality of the network or digital asset.