Nine Guidelines to Keep Broker-Dealers Out of Trouble with the SEC in Regards to Digital Asset Securities

The world of digital assets is continuing to evolve. As the SEC noted recently – “a digital asset security that is not in the exclusive physical possession or control of the broker-dealer because, for example, an unauthorized person knows or has access to the associated private key (and therefore has the ability to transfer it without the authorization of the broker-dealer) would not be held in a manner that complies with the possession or control requirements of Rule 15c3-3 and thus would be vulnerable to the risks the rule seeks to mitigate.”

As you can see, it’s crucial that you employ a firm that can help ensure you’re not risking SEC enforcement regarding compliance with the Customer Protection Rule as it relates to digital asset securities. As a broker-dealer, here are nine ways to make sure you can reasonably seek relief.

Have access to the digital asset securities and be able to transfer them on the associated distributed ledger technology.

Limit your business in dealing, effecting transactions, maintaining custody or and/or working within an alternative trading system for digital asset securities, but may hold proprietary positions in traditional securities in order to meet your firm’s minimum net capital requirements or to hedge risks in traditional securities and digital asset securities.

Establish, maintain and enforce well designed policies and procedures of whether a particular digital asset is a security that is offered and sold under a registration statement or exempt, and you meet the requirements to comply with federal securities laws in this area.  

Create, follow and enforce written policies and procedures regarding conduct and documentation in regards to the characteristics of a digital asset security’s distributed ledger technology and related network before taking custody, and then review it at regular intervals. 

Don’t seek to maintain custody of a digital asset security if you’re aware of any relevant security or operational problems or weaknesses with the distributed ledger technology and the related network used to access and transfer the digital asset security.

Create, follow and enforce written controls that are consistent with industry best practices that help protect against theft, loss and unauthorized or accidental use of the related private keys for the digital asset security under your custody. 

Create a written plan of steps your firm will take in case of blockchain malfunctions, hard forks, 51% attacks or airdrops and what you will do to allow your firm to comply with a court-ordered freeze or seizure and/or allow for the transfer of the digital asset securities held by your company to another broker-dealer, a trustee, receiver, liquidator, or similar person/firm, or to another appropriate person, in case you can’t continue maintaining custody because of a bankruptcy, receivership, liquidation, or similar proceeding.

Provide written disclosures to prospective customers that you’re in possession or control of digital asset securities held for the customer (for the purposes of paragraph (b)(1) of Rule 15c3-3 based on compliance with the SEC’s statement) about the risks of investing in or holding digital asset securities that must prominently talk about that digital asset securities may not be “securities” as defined in the Securities Investor Protection Act of 1970 (“SIPA”)—and that digital asset securities that are “investment contracts” under the Howey test but are not registered with the Commission are excluded from SIPA’s definition of “securities”—and so the protections under SIPA may not apply. You must also describe the risks of fraud, manipulation, theft, and loss associated with digital asset securities, describe the risks relating to valuation, price volatility, and liquidity associated with digital asset securities, and describe, without compromising your security protocols, the processes, software/hardware systems, and any formats or systems you use to create, store, or use your private keys and protect them from loss, theft, or unauthorized or accidental use.

Enter into a written agreement with each customer that sets forth the terms and conditions with respect to receiving, purchasing, holding, safekeeping, selling, transferring, exchanging, custodying, liquidating and otherwise transacting in digital asset securities on behalf of the customer.Bull Blockchain Law can ensure you are fully compliant and protected to the full extent of the law in regards to digital asset securities. Visit https://bullblockchainlaw.com/practice-areas/digital-assets-securities/ to learn more.

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