Potential Extension of Non-Enforcement Policy for PTE 2020-02

It appears that the Acting Head of the Employee Benefits Security Administration, Ali Khawar, suggested at the annual meeting of the American Society of Pension Professionals & Actuaries that the temporary enforcement policy surrounding PTE 2020-02 may be extended.

PTE 2020-02 provides relief for rollover recommendations that result in prohibited transactions, so long as the exemption conditions are satisfied. In addition to the other conditions, financial institutions must document and disclose in writing the specific reasons that a rollover recommendation is in the retirement investor’s best interest.

According to a source in attendance, Acting Head Khawar intimated that an announcement would be made in the very near future.

Investment advisers should plan to adopt and implement their policies and procedures by the current December 20, 2021 deadline, but an extension would be welcomed as investment advisers finalize their processes.

The Unchecked Growth and Lack of Responsible Regulation in Digital Assets

Someone recently asked me why the unchecked growth and lack of responsible regulation in the digital asset space bothered me. It was a fair question from someone I respect in the space, so I wanted to take the time to address it. By way of background, I am an asset management attorney. I represent financial institutions—namely investment advisers—complying with federal securities laws. I represent several registrants who tailor their services to Bitcoin and other digital assets. I have done considerable legal and regulatory due diligence on digital asset managers and platforms for clients.

I.                   Investor Protection

Investors, especially retail investors, deserve investment advice that is in their best interest. They deserve to have complete information about the investments that are being hawked to them. They deserve to interact with counterparties that are not gouging, defrauding, or deceiving them. They deserve to be able to believe that markets aren’t being manipulated.  Some even believe that investors deserve more paternalistic protection from harming themselves[1].

State and federal securities laws have developed over the years to provide these protections. On the whole, I believe that federal securities laws have served us well and have ultimately done more good than harm. They have protected investors, promoted fair and efficient markets, and have adequately assisted with capital formation for companies across the country.  They are arguably responsible for the status of the United States as a global leader—at least in part.

As it relates to digital assets, they resemble securities (even if some might not technically be in a legal sense). People are investing in them, recommending them, managing them, trading them on exchanges, placing them in pooled funds, buying them on margin, lending them, securitizing them, all with the expectation of making a profit.

Why shouldn’t the same regulatory system that has served us well over the years apply to digital assets, their markets, and their market participants? I believe that doing so provides ample investor protections without necessarily stifling innovation.

II.                Unfair Advantage – Regulatory Arbitrage

Investments are always competing for money. Whether it be real estate, art, securities, franchises, or digital assets. Everyone is competing for the next investable dollar. Given the similarity between securities and digital assets, I suspect that any regulatory arbitrage between the two encourages capital to flow to the underregulated asset—in this case—digital assets.

Take for example Tom Brady’s recent tweet and video promoting FTX. If FTX were a securities broker-dealer, this advertisement would have been less likely to have been aired. It showed people quitting their jobs to invest in digital assets. Without substantiation, it claims to be the “most trusted way to buy & sell crypto”. With this type of advertisement, FTX is able to promote itself in ways that Robinhood (or perhaps Fidelity is a better example) wouldn’t.  In the competition of investable assets between securities and digital assets, this regulatory arbitrage would seem to help more dollars flow to digital assets.

From a policy perspective, we ought to be asking, “Do we want this regulatory arbitrage to exist? Do we want assets to flow from securities markets to digital asset markets? What externalities is this regulatory arbitrage creating?” I personally don’t want this regulatory arbitrage to exist. I don’t want digital asset markets taking opportunities from securities markets solely because of this arbitrage. I want to see a fair fight.

Full disclosure. I represent registrants in the financial services industry complying with its various laws, regulations, and guidance. If there are more rules or an extension of current rules to digital assets and their marketplaces, I could stand to benefit. I could have more clients, more regulatory issues to advise on, and more examinations and enforcement actions to defend.

III.             The Hysteria

The recent tulip-like hysteria of investors seeking to invest in digital assets makes me uneasy. There, I said it. Young and old alike are watching their favorite professional athletes promote Bitcoin and digital asset exchanges—almost always without disclosure about their net worth, the percentage of their portfolio they are investing, and their compensation for making favorable statements. While professional athletes are extremely influential because of their fame and place in our society, they aren’t necessarily the best barometers of investing success. Professional athletes have historically been amongst some of the most likely investors to be defrauded or preyed upon financially.

There seems to be substantially more people promoting Bitcoin and other digital assets than there are tempering expectations about these assets, the risks of investing in Bitcoin and other digital assets, or how to do it responsibly. For example, those electing to receive their entire paychecks in Bitcoin might not be prepared to lose forty percent of their income or savings in a few days, but this could have happened to someone implementing this strategy in May of 2021.

Another facet of the hysteria that worries me is many who are aggressively investing in and recommending digital assets are subject to confirmation bias and are currently trapped in an echo chamber. Bitcoin and other digital assets have performed extremely well in the last few years. Anyone who has been invested in digital assets early enough has experienced investment returns like we have never witnessed in a short period. I continue to hear anecdotes of those investing a few thousand dollars in a relatively new digital asset and now have millions of dollars in gains just a couple of years later. These are the stories that become legend, but not everyone will obtain these results. This is where you can call me a boomer or remind me to “have fun staying poor”. For every early Ethereum millionaire, there will be XYZ token losers. For every early investor in Amazon, there were as many in Webvan and Pets.com. It is impossible to predict whether Bitcoin or any other digital asset will be worth as much as it is today in the future.

Social media algorithms also cause us to see commentary that intrigues other internet users and ourselves. It then keeps that information fresh in our minds and constantly on our screens. On Twitter, an army of mostly anonymous Bitcoin and digital asset fans exist that challenge and attack others if they remotely question the utility or merit of these assets. This leads many to remain quiet about expressing their reservations or hesitancy on digital assets. All of this is to say that there is a vacuum for pro-digital asset views, their markets, and their market participants.

These factors make me pause in considering the future of this young industry and make me favor regulation to promote fair and honest markets and discourse about these assets.

IV.             Personal Hesitancy

Generally, I am a big proponent of saving and responsible investing. My father passed down his philosophy of investing (and life) and it has served both of us well. I won’t gamble more than $100 in Atlantic City. I don’t bet more than $200 a year on sporting events or fantasy sports. I max out my IRA, save as much as I can, and invest in well-known stocks, ETFs and index funds. I avoid complex and alternative investments. I admit that I am a boring investor and I am never going to hit a grand slam. I am alright with this strategy, because I’m also not willing to take risks with mine or my family’s future. I have moments where I want to commit a substantial amount of money to Bitcoin, Ethereum, and Solana, but then I remind myself to stay my own course.

The only risk I see of staying the course as an investor is if (i) Bitcoin or another digital asset replaces or diminishes the standing of the US Dollar, or (ii) the digital asset ecosystem somehow replaces the current financial system, in either case rendering my income and my assets worthless or worth less. I view each of these two possibilities as incredibly more remote than the risk created by investing in Bitcoin or in the new digital asset ecosystem. For that reason, I won’t personally invest any more of my assets in Bitcoin[2] or any other digital asset and will continue to reassess these factors on a periodic basis.  

As someone in this industry, I see incredible value in blockchain technology. I see benefits in digital assets eliminating the concept of the unbanked. I can see tokens replacing certain asset classes—such as gold. But, at the end of the day, I don’t believe the risk-to-reward ratio of having meaningful exposure to this asset class is prudent for myself, my family, or large swaths of retail investors currently.

V.                Not All Players are Doing it Wrong

I think there are some players in this space that are doing a fantastic job in telling a fair and balanced story about digital assets and keeping the exuberance rational. Just to name a couple. Onramp is educating advisors on digital assets first and foremost, but also helping advisors plan and manage held away digital assets. Similarly, Interaxis is leading with education for the financial advisor community. Neither Onramp nor Interaxis is a client of mine currently, but Tyrone Ross of Onramp has been gracious about inviting me to share my legal knowledge about digital assets as it relates to regulatory issues.

VI.             Conclusion

I’m just one federal securities lawyer-investor providing his thoughts about the federal regulatory regime surrounding digital assets and the risk involved with them. I’d encourage you to do your own homework and make your own choices.

[1] This is mostly beyond the scope of this article. I used to be a free market believer. Over the years, I have seen too much self-induced harm involving retail investors and my view on paternalism is evolving.

[2] I have made a few very small investments in Bitcoin and Polygon.

“Qualified Client” Definition Amended to Keep Pace with Inflation

On June 17, 2021, the Commission ordered that Rule 205-3 under the Investment Advisers Act of 1940 be amended so that the term “qualified client” means (i) natural person who, or a company that, immediately after entering into the contract has at least $1,100,000 under the management of the investment adviser; and (ii) a natural person who, or a company that, the investment adviser entering into the contract (and any person acting on his behalf) reasonably believes, immediately prior to entering into the contract, has a net worth (together, in the case of a natural person, with assets held jointly with a spouse) of more than $2,200,000. Both prongs have increased by $100,000 to keep pace with inflation.

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How Should We Perform an Annual Review Under Rule 206(4)-7?

The most frequent quip I hear from owners and executives of investment advisers relating to compliance is that what keeps them up at night is they “don’t know what they don’t know.” I sympathize with them about the unknown and try and help insure that they are positioned to be compliant with federal and state securities laws. Rule 206(4)-7 requires each registered adviser to review its policies and procedures annually to determine their adequacy and the effectiveness. This rule serves as an annual reminder of the knowledge gap that owners and executives face without a trusted legal and compliance partner. This post is intended to provide a high level overview for owners and executives of things they ought to consider as part of this annual review process.

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Investment Advisers with Under $100MM in Assets Are Successful Too!

Recently, Bruce Kelly of InvestmentNews published “Advisers, shoot for $100 million in AUM before going indie“. The article summarized a virtual conference panel that InvestmentNews RIA Summit held where the message from most panelists seemed to have suggested that investments advisers starting their business with less than $100 million under management would be better served not starting their own business. I want to dispel that notion.

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The Problem With Foreign Clients and Clients Residing in Foreign Jurisdictions

One of the most frequently asked questions I receive from investment advisers is whether they can enter into an advisory relationship or manage assets for a client located in a foreign country. Like the United States, foreign jurisdictions have laws that require registration for rendering investment advice to individuals residing within their jurisdiction. This post is intended to provide a bit more context for advisers trying to work through these issues.

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Signs You May Want to Reconsider Your Compliance Partner

I have a lot of respect for compliance professionals, Chief Compliance Officers, legal counsel and anyone in a regulated environment that is trying to keep their client out of trouble. At the same time, I occasionally am told stories involving compliance consultants that blow me away. So I decided to compile a list of signs that may signal you need a new compliance professional or a law firm to assist you with compliance.

  1. I drafted this report for you. It identifies every single deficiency that I uncovered. There are a lot of them and things don’t look so good for your firm. It is a roadmap for the Division of Examinations, FINRA, or a state securities regulator. I didn’t consider whether the contents of this report were privileged before sending it to you. Good luck!
  2. When you need to reach them for a compliance emergency, you can’t. They clock out at 4:30 or 5:00pm and aren’t prepared to help you or your business get it right after hours.
  3. They tell you what everyone else is doing, what you “need” to be doing; and they don’t tell you what the law actually says you must be doing.
  4. They defer to telling you “no”, because it makes their life easier.
  5. They aren’t able to provide you with a risk assessment to make informed business decisions.
  6. Hold on…that is a legal document. I can’t help you out with that. You are going to have to contact a lawyer.
  7. Hold on…that is a legal question. I can’t help you out with that. You are going to have to contact a lawyer.
  8. When asked about exploring a new, but related line of business, they tell you that they don’t have any experience with that area.
  9. They write poorly, but you need them to draft written responses to a deficiency letter.
  10. They gave you incorrect advice and it cost you time, money or energy to correct.

SEC Staff to Advisers: “You Must Fully Comply with the New Marketing Rule. You Can’t Partially Opt-In.”

On March 18, 2021, the staff of the Division of Investment Management released an FAQ regarding the new marketing rule. The new rule becomes effective May 4, 2022, but has a compliance date of November 4, 2022. The FAQ makes clear that an adviser may comply with the new rule prior to November 4, 2022, but they must be fully compliant with all aspects of the new rule when they opt in to compliance. The full text of the FAQ is set forth below:

Q: I understand that an adviser must comply with the amended adviser marketing rule with respect to its advertising and solicitation activities by the compliance date (November 4th, 2022), which is 18 months after the effective date of the rule. May an adviser choose to comply with some of the marketing rule requirements before the compliance date, but not comply with others?

A:  No. An adviser may choose to comply with the amended marketing rule in its entirety any time starting on the effective date, May 4th, 2021. Until an adviser transitions to the amended marketing rule, the adviser would continue to comply with the previous advertising and cash solicitation rules and look to the staff’s positions under those rules. The staff believes an adviser may not cease complying with the previous advertising rule and instead comply with the amended marketing rule but still rely on the previous cash solicitation rule. Advisers are reminded that they should review their compliance policies and procedures in light of regulatory developments, including the adoption of the amended marketing rule. In addition, the staff believes that when advisers transition to the amended marketing rule, they will need to implement any revisions to the written compliance policies and procedures necessary so that they are reasonably designed to prevent violations of the amended marketing rule. Advisers are also reminded that they are required to maintain a copy of all compliance policies and procedures in effect at any time within the previous five years, and that it should be clear when those policies and procedures were in effect.

SEC Issuing Legally Questionable Moratoriums on Registration for Foreign Investment Adviser Applicants

Investment advisers with their principal place of business in foreign jurisdictions have recently become subject to moratoriums on registration because the U.S. Securities and Exchange Commission (the “Commission” or the “SEC” ) and its Staff have concerns that these foreign applicants may be unable or unwilling to make their books and records available for inspection or examination due to local privacy laws. Israel is one of those countries. The United Kingdom was one of these jurisdictions until late 2020.

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