On September 25, 2020, the SEC’s Division of Trading and Markets (Division) issued a no-action letter that allows for another settlement method with respect to digital asset security transactions effected through an alternative trading system (ATS). The no-action letter was provided in response to a request from FINRA and had the effect of supplementing guidance previously provided jointly by the Division and the Office of General Counsel, FINRA, in the form of a Joint Staff Statement on Broker-Dealer Custody of Digital Asset Securities (Joint Statement).
Summary of the no-action letter
The no-action letter applies to matched buy and sell orders in “digital assets securities” transacted on an ATS. The no-action letter defines the term “digital asset” to mean “an asset that is issued and/or transferred using distributed ledger or blockchain technology. . . .” Examples of digital assets include “virtual currencies,” “coins,” and “tokens.” The no-action letter refers to digital assets that are also securities as “digital asset securities.”
As stated above, the no-action letter supplements guidance previously provided in the Joint Statement. Though the Joint Statement is primarily focused on issues related to custody of digital asset securities, it also discusses several non-custodial activities. Of relevance to the no-action letter, one such activity involves a broker-dealer who operates an ATS (an Operating Broker-Dealer) matching buy and sell orders in digital assets securities on an ATS where the trades are either settled directly between the buyer and seller or the buyer and seller give instructions to their respective custodians to settle the transactions.
Significantly, neither settlement method results in the Operating Broker-Dealer guarantying or otherwise having the responsibility for settling the trades. Nor does either settlement method result in the Operating Broker-Dealer exercising any control over the digital asset securities being sold or the cash being used to purchase the digital assets.
As a result, the above described settlement methods do not implicate the requirements under paragraph (b) of Securities Exchange Act Rule 15c3-3 (17 C.F.R. §240.15c3-3) (Customer Protection Rule) that broker-dealers must obtain and maintain physical possession or control of all fully paid for or excess margin securities carried by a broker-dealer for a customer. This is important because the Joint Statement also raised concerns over the ability of broker-dealers to comply with the possession or control requirements of the Customer Protection Rule in the context of digital asset securities.
The no-action letter describes the non-custodial method referenced above as involving a four-step process consisting of the following steps:
- Step 1 – the buyer and seller send their respective orders to the ATS;
- Step 2 – the ATS matches the orders;
- Step 3 – the ATS notifies the buyer and seller of the matched trade; and
- Step 4 – the buyer and seller settle the transaction bilaterally, either directly with each other or by instructing their respective custodians to settle the transaction on their behalf.
In place of the above four-step process, the no-action letter contemplates the use of a three-step process that allows the ATS, if so instructed by the buyer and seller, to provide notice of the matched trade directly to the custodians who, in turn, would settle the trade based upon previous authorization from the buyer and seller.
The new process, as set forth in the no-action letter, consists of the following three steps:
- Step 1 – the buyer and seller send their respective orders to the ATS, notify their respective custodians of their respective orders submitted to the ATS, and instruct their respective custodians to settle transactions in accordance with the terms of their orders when the ATS notifies the custodians of a match on the ATS;
- Step 2 – the ATS matches the orders; and
- Step 3 – the ATS notifies the buyer and seller and their respective custodians of the matched trade and the custodians carry out the conditional instructions.
The no-action letter references Operating Brokers-Dealers as asserting that the new process reduces operational and settlement risk. At the same time, the new process, like the existing four-step process, should not trigger concerns with respect to compliance by the Operating Broker-Dealer with the possession or control requirement.
Perhaps recognizing that the new three-step process does increase, even if only slightly, the involvement in the settlement process of the Operating Broker-Dealers, the no-action letter conditions its relief on an Operating Broker-Dealer maintaining a minimum of US$250,000 in net capital, which is the minimum capital amount required of brokerage firms that carry customer positions, and entering into an agreement with its customers that clearly informs the customers that the Operating Broker-Dealer does not guarantee or otherwise have responsibility for settling the trades.
Significantly, the no-action letter also imposes the following two conditions, or “circumstances,” on Operating Broker-Dealers who rely on the no-action letter:
- The Operating Broker-Dealer “has established and maintained reasonably designed procedures to assess whether a digital asset security was offered and sold initially pursuant to an effective registration statement or an available exemption from registration, and whether any secondary transactions of the digital asset security on or through the ATS are made pursuant to an effective registration statement or an available exemption from registration;” and
- “The transactions in digital asset securities otherwise comply with the federal securities laws.”
Interestingly, neither of these two conditions has anything to do with the Customer Protection Rule. Instead, they obligate an Operating Broker-Dealer to police or monitor digital asset securities traded on an ATS for compliance with both the registration requirements of the Securities Act of 1933 (’33 Act) and with the federal securities laws more generally.
Significance of the compliance obligations imposed by the no-action letter
Compliance with the no-action letter’s conditions will likely require implementation of a comprehensive, well-funded, and well-staffed program that provides for a documented review and approval process related to every digital asset security to be traded on an ATS and adequate monitoring of each transaction.
We understand that some Operating Broker-Dealers already request so-called “listing agreements” from issuers as a condition to allowing the issuers’ digital asset securities to trade on their ATSs. These listing agreements include representations and warranties with respect to the issuers’ compliance with registration and other securities law requirements. Operating Broker-Dealers relying on the no-action letter may wish to employ similar agreements. Further, to the extent they do not already do so, Operating Broker-Dealers relying on the no-action letter should also consider obtaining representations and warranties from sellers to ensure that each seller has a valid exemption from the registration requirements of the ’33 Act.
Additionally, for the reasons discussed below, Operating Broker-Dealers relying on the no-action letter should include controls in their compliance programs to address relevant obligations under the Bank Secrecy Act, including monitoring for “red flags” that may be indicative of reportable actions under the Department of the Treasury’s suspicious activity reporting rule (31 C.F.R. §1023.320).
Suspicious activity reporting considerations
FINRA Rule 3310 (Anti-Money Laundering Compliance Program) requires all member firms to develop and implement written anti-money laundering (AML) programs that include policies and procedures for monitoring for and reporting suspicious activities. A firm’s AML program should reflect consideration of the 100+ items listed in FINRA Regulatory Notice 19-18 as money laundering red flags potentially indicating a need for further review and filing of a suspicious activity report (SAR).
The SEC and FINRA have interpreted several of the red flags listed in FINRA Regulatory Notice 19-18 as imposing obligations on clearing firms to surveil customer transactions in penny stocks for compliance with the registration requirements of the ’33 Act and to file SARs where such transactions are suspected of having violated the registration requirements of the ’33 Act. Clearing brokers who have allowed their customers to engage in penny stock transactions have not infrequently faced enforcement actions resulting in fines of hundreds of thousands of dollars, and in several cases millions of dollars, on account of widespread failures to file SARs with respect to suspicious transactions in penny stocks. Enforcement cases have also been brought against compliance officers due to their involvement in the clearing firms’ SAR filing failures.
In light of the positions that the SEC and FINRA have taken regarding the SAR filing obligations of clearing firms with respect to surveilling penny stock transactions for ’33 Act compliance, and their aggressive enforcement of such obligations, it would not be surprising if the SEC and FINRA took similar positions with respect to broker-dealers who effect transactions in digital asset securities. Indeed, such an approach is made more likely in that it would help fill the compliance monitoring role that clearing firms would normally be expected to fill but cannot given their absence from such transactions as a result of the unsettled custody issues surrounding digital asset securities. As a result, all broker-dealers that effect transactions in digital asset securities, and not just Operating Broker-Dealers relying on the no-action letter, should carefully consider their compliance obligations with respect to such transactions under FINRA Regulatory Notice 19-18 and their ability to adequately monitor for red flags and ensure the filing of SARs where appropriate.