SEC Risk Alert

The Division of Examinations of the U.S. Securities and Exchange Commission (“SEC”) recently issued a Risk Alert regarding the risks it has identified after examining investment adviser firms managing digital assets that are securities (“Digital Asset Securities”) for their clients or pooled investment vehicles (e.g., private funds). Click here to view this SEC Risk Alert entitled “The Division of Examinations’ Continued Focus on Digital Asset Securities” issued February 26, 2021.

The SEC’s Division of Investment Management noted that digital assets present unique risks to investors and the underlying distributed ledger technology has many distinct features requiring the updating and enhancement of investment adviser firm’s policies and procedures.

The SEC Risk Alert identified the following as the areas it will focus upon when examining investment adviser firms which manage digital assets.

Portfolio Management of Digital Asset Securities

With respect to portfolio management of Digital Asset Securities, the SEC intends to review the investment adviser firm’s policies and procedures related to the following topics:

Classification of digital assets as securities;
Due diligence of digital assets (e.g., understanding the digital asset, wallets, or any other software used to interact with the relevant digital asset network, and the relevant liquidity and volatility of the digital asset);
Evaluation and mitigation of risks related to trading venues and trade execution or settlement facilities (e.g., with respect to security breaches, fraud, insolvency, market manipulation, the quality of market surveillance, KYC/AML procedures, and compliance with applicable rules and regulations);
Management of risks and complexities associated with “forked” and “airdropped” digital assets (e.g., allocations thereof across client accounts, conflicts of interest, or other issues that may result from the fork or airdrop event); and
Fulfillment of their fiduciary duty with respect to investment advice – across all client types.

Books & Records Related to Digital Asset Securities

The SEC will examine whether investment adviser firms are making and keeping accurate books and records related digital assets including trading records. The SEC warned that digital asset trading platforms vary in reliability and consistency with respect to books and records and an investment adviser’s policies and procedures should consider such with respect to books and records.

Custody of Digital Asset Securities

The SEC will examine whether investment adviser firms are complying with the SEC’s custody rule (Rule 206(4)-2 under the Investment Advisers Act of 1940 as amended) and review the risks related to custody of digital assets including the following:

Unauthorized transactions related to digital assets;
Controls and safekeeping of digital assets (e.g., employee access to private keys and trading platform accounts);
Business continuity plans where key personnel have exclusive access to private keys;
How the adviser evaluates harm due to the loss of private keys;
Reliability of software used to interact with relevant digital asset networks;
Storage of digital assets on trading platform accounts and with third party custodians; and
Security procedures related to software and hardware wallets.

Disclosures of Unique Risks of Digital Assets

The Division of Examinations will be reviewing how an investment adviser firm discloses the unique risks of digital assets in its various forms of communications to investment advisory clients or private fund investors. The SEC exam staff will be evaluating the digital asset risk disclosures by an investment adviser firm with respect to (i) complexity of the product or underlying technology, (ii) technical, legal, market and operational risks (including custody and cybersecurity), price volatility, illiquidity, valuation methodology, related-party transactions and conflicts of interest.

Valuation of Digital Assets

The SEC express concerned about various challenges facing an investment adviser firm’s valuation of a digital assets due to market fragmentation, illiquidity, volatility, and the potential for manipulation. The examinations by the SEC will include a review of the valuation methodology utilized by the investment adviser to determine fair market valuation, valuation after significant events and recognition of forked or airdropped digital assets. Additionally, the SEC staff will review the investment adviser firm’s disclosures related to valuation methodologies and the impact of such valuation on calculation of advisory fees.

Digital Assets Impact on Investment Adviser Registration Status

The SEC will be reviewing how an investment adviser utilizes digital assets for purposes of calculating regulatory assets under management for purposes of registering with the SEC as an investment adviser or how the characterization of digital assets makes effect a private fund’s exemption from registering as an investment company.

Broker-Dealers, Exchanges and Transfer Agents

This Risk Alert also provided guidance as to the SEC staff examination of broker-dealers, securities exchanges and transfer agents related to Digital Asset Securities. Please click here for more details.

Contact Us

To the extent that your investment adviser firm is managing digital assets, this SEC Risk Alert is a good road map of the issues unique to digital assets that your compliance program should be addressing. If your investment adviser firm is interested in learning more about how RIA Compliance Consultants can assist you, please call 877-345-4034 or click here to schedule an introductory call using our online calendar.

Related Resources

Webinar: 2021 SEC Exam Priorities (3/4/21)

SEC Exam – Best Practices Checklist

SEC Exam – Log of Requested Docs & Info

SEC Exam – Response to Deficiency or Findings Letter from Securities Regulator