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The Application of Broker-Dealer and Exchange Regulations to Secondary Markets – Thought Leaders

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The Application of Broker-Dealer and Exchange Regulations to Secondary Markets - Thought Leaders

Sweat the Small Stuff and Maybe the Bigger Issues Will Take Care of Themselves.

The Application of Broker-Dealer and Exchange Regulations to Secondary Markets Trading of Digital Assets.

The U.S. Securities and Exchange Commission’s (“SEC” or “Commission”) recent enforcement actions involving AirFox, Paragon, Crypto Asset Management, TokenLot, and EtherDelta’s founder illustrate that market participants must still adhere to well-established and well-functioning federal securities law framework when dealing with technological innovations, regardless of whether the securities are issued in certificated form or using new technologies, such as blockchain.

Broadly speaking, the issues raised in these actions fall into three categories: (1) initial offers and sales of digital asset securities (including those issued in initial coin offerings (“ICOs”)); (2) investment vehicles investing in digital asset securities and those who advise others about investing in these securities; and (3) secondary market trading of digital asset securities. 1 See Statement on Digital Asset Securities Issuance and Trading by the SEC’s Division of Corporation Finance, Division of Investment Management, and Division of Trading and Markets (Nov. 16, 2018). https://www.sec.gov/news/public-statement/digital-asset-securites-issuuance-and-trading  This article discusses some of the nuances of trading of digital asset securities in the secondary market.

As the Commission’ statement made clear “[a]ny entity that provides a marketplace for bringing together buyers and sellers of securities, regardless of the applied technology, must determine whether its activities meet the definition of an exchange under the federal securities laws. Exchange Act Rule 3b-16 provides a functional test to assess whether an entity meets the definition of an exchange under Section 3(a)(1) of the Exchange Act. An entity that meets the definition of an exchange must register with the Commission as a national securities exchange or be exempt from registration, such as by operating as an alternative trading system (“ATS“) in compliance with Regulation ATS.” 2 Id.

In determining whether an individual, entity or platform is acting as a broker-dealer or an exchange, the SEC will conduct its analysis based upon 1) the totality of the activities conducted by the participant as well as 2) the functional reality of what those activities achieve.  If an entity provides a marketplace for bringing together buyers and sellers of digital asset securities, the SEC may find that such an entity is operating as an exchange. If an entity or a person is effecting transactions in digital assets or buying and selling digital assets for its own account, the SEC may find that such an entity or individual is acting as a broker or dealer in securities. 3 See Scheibe, Taub, Selinger, Steele and Woodward, SEC DIVISIONS ISSUE DIGITAL ASSET SECURITIES STATEMENT November 28, 2018 https://www.mwe.com/insights/sec-divisions-issue-digital-asset-securities-statement/  Any such broker-dealer must register with the SEC, as well as become a member of a self-regulatory organization, such as FINRA.  Registration as a broker or dealer also results in adherence to a far-reaching compliance and investor protection regime.

Some of the most basic requirements that can pose roadblocks or speedbumps for the development of secondary market trading of digital assets include:

  • Books and Records: Registered broker-dealers must make and maintain current books and records. Rules 17a-3 and 17a-4 under the Exchange Act and FINRA Rule 4511, for example, require that broker-dealers preserve certain records for specified periods of time and use certain technology such as write once read many (WORM) format. How can a digital-asset ATS be sure that the use of Digital Ledger Technology for recording and maintaining such information is in compliance with the SEC and FINRA’s requirements? The short answer should be that the blockchain is immutable and thus satisfies this requirement but some regulatory assurances on this would be helpful.

 

  • Customer Protection: Under SEC Rule 15c3-3, a broker-dealer must maintain the physical possession or control of all fully paid securities and excess margin securities carried by the broker-dealer for the account of its customers. It is currently unclear whether the requirements of Rule 15c3-3 are met where transactions in digital securities are recorded on a database that is maintained over a public or private network. Does a Broker-dealer have the ability to demonstrate receipt, delivery and custody of securities and other assets of their customer’s accounts where such records are held on chain? For example, is it required that ICO tokens, securities or other assets be held in a customer’s account (wallet) or does the ATS sponsor need to provide for the custody of these securities and assets with a third-party qualified custodian?

 

  • Examinations: Broker-dealers and regulators are still figuring out these new technologies and how existing regulations apply to them. FINRA’s current examination module for an ATS may very well be ill suited to a digital asset ATS.  FINRA in Notice 18-20 (July 6, 2018) made clear that is seeking additional information from broker-dealers and “to encourage each firm to promptly notify FINRA if it, or its associated persons or affiliates, currently engages, or intends to engage, in any activities related to digital assets”.

 

  • Net Capital Rules: The Commission’s net capital rules will arguably have the most severe impact on the development of secondary trading markets in digital assets. The SEC has previously stated that Exchange Act Rule 15c3-1 “requires broker-dealers to maintain a minimum level of net capital (consisting of highly liquid assets) at all times.” 4 See SEC Securities Exchange Act Release No. 70073 (July 30, 2013) (Order Approving File No. S7-23-11). FINRA Rule 4100 Series (Financial Condition) expands the various requirements for broker-dealers to ensure compliance with the SEC’s net capital rules.  Given that digital assets coming off the Reg D imposed restriction period are unlikely to meet the requirements for highly liquid assets, these net capital requirements may pose the biggest hurdle in allowing for deep and liquid markets to come into being in the near term. In order to allow this nascent digital asset securities market to grow and bring liquidity to shareholders, the Commission and FINRA may wish to allow for a pilot program to facilitate the development and oversight of this market.

 

In conclusion, the promise of DLT and the application of Exchange Act Rules still have some ways to go before digital assets can be traded freely and transparently on exchanges and ATS’. That being said, it’s not too early for market participants in this space and regulators to come together to address a roadmap for the near future in the U.S. A discussion of some of these topics at the upcoming SEC Forum 5SEC Staff to Hold Fintech Forum to Discuss Distributed Ledger Technology and Digital Assets, SEC Press Release 2019-35 (March 15, 2019) is essential for furthering this dialogue and unlocking the promise of liquidity that digital asset issuers aspire to.

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Considered to be a blockchain regulation visionary, Gautam S. Gujral is the Co-Founder and General Counsel at Vertalo SEZC.

Regulation

Supreme Court Reins in SEC on Disgorgement

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Supreme Court Reins in SEC on Disgorgement

While the SEC holds a huge amount of influence and power, they do not operate without oversight, themselves.  This was on full display on Monday, as the U.S. Supreme Court issued a new ruling on SEC authority surrounding disgorgement.

Essentially, it was ruled that, while the SEC will retain the ability to seek disgorgement from offending parties, it will be limited to their profits.  This means that if a company raises $50M through illegal means, the SEC can only seek to retrieve funds up to the $50M minus any genuine operating costs.

The purpose for this limit is a simple one – disgorgement is permitted as a remedial, rather than punitive, action.  If the SEC were to seek funds exceeding what was raised, it would no longer represent a retrieval of funds, but a punishment for their actions.

Furthermore, the ruling indicates that funds, retrieved through these means, are to be used as compensation for victims that have lost money.

Disgorgement

For those unfamiliar with disgorgement, it refers to the repayment of funds received/generated by parties which violated existing laws.

In recent years, disgorgement has been a commonly used method of the SEC, as made evident in various cases stemming from the 2017 ICO boom.

Commentary

For those interested, the entirety of the U.S. Supreme Court’s ruling can be found HERE.  While there are various intricacies involved, the court’s decision can be broadly summarized by their statement, as follows.

“The Court holds today that a disgorgement award that does not exceed a wrongdoer’s net profits and is awarded for victims is equitable relief permissible under §78u(d)(5).”

Recent Examples

As aforementioned, the SEC has turned to disgorgement on various occasions, as of late.  The following articles are a few examples of it being used in crypto based cases.

After Months of Silence by ICOBox, the SEC Seeks ‘Default Judgement’ and ‘Permanent Enjoinment’

SEC Levies Various Charges against ‘Teshuater’

Veritaseum Hit with $8 Million in SEC Fines

SEC

Based in the United States, the SEC is a government run regulatory body.  This outfit is tasked with fostering safe, and transparent, markets surrounding securities.  This entails both the creation, and enforcement, of laws surrounding the sector.

SEC Chairman, Jay Clayton, currently oversees operations.

In Other News

While Jay Clayton may still be in charge at the SEC, his time at the helm may soon be coming to a close.  We recently touched on a tricky situation, currently evolving, which would see Clayton depart the SEC for a position as an Attorney General in Southern New York.

SEC Chairman Jay Clayton Moving On?

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Regulation

SEC Chairman Jay Clayton Moving On?

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SEC Chairman Jay Clayton Moving On?

Caught in the Middle

Jay Clayton, Chairman of the SEC, has found himself caught in the middle of a tricky situation.  The story goes like this:

On June 19th, U.S. Attorney General, William Barr, announced the Trump administration’s intent to name Jay Clayton the new U.S. Attorney for Southern New York.

This announcement soon became a major point of contention, as Geoffrey Berman (the current U.S. Attorney for Southern New York) had refused to abandon his post.  This stance was changed, however, when assured that his departure would not derail current investigations.

Replacing Geoffrey Berman for the interim is Deputy U.S. Attorney, Audrey Strauss.

Burnt Bridges?

While pure speculation at this point, many believe that these actions were taken due to ‘burnt bridges’ between Berman and the Trump Administration.  More specifically, Berman was/is at the helm of various corruption inquiries into associates of the POTUS.

The situation has seen various senators weigh-in on the situation.  Notably, Senator Chuck Schumer believes an immediate investigation should be launched into the situation.  Furthermore, he had strong words for Clayton, himself, stating,

“Jay Clayton can allow himself to be used in the brazen Trump-Barr scheme to interfere in investigations by the U.S. Attorney for SDNY, or he can stand up to this corruption, withdraw his name from consideration, and save his own reputation from overnight ruin.”

Back to Roots

If this move were to happen, it would not necessarily mark a return to his roots.  Prior to his tenure at the SEC, Jay Clayton was a seasoned corporate lawyer, with decades of experience.  What he lacks, however, is experience as a prosecutor – typically a prerequisite for Attorneys Generals.

It’s Complex

While his duties stretched far beyond regulating the burgeoning blockchain sector, Clayton developed a complex relationship with the community through his time at the SEC, thus far.

Clayton has many detractors from the crypto community, as he has had a hand in the denial of many Bitcoin ETF applications.

At the end of the day, however, the world of crypto remains rife with scams,y.  Despite having massive potential, Clayton has, for the most part, made sound decisions in regulating the growth of crypto base endeavours.

Be Careful what you Wish For

While Clayton may not be pro-crypto, there are many examples throughout his tenure of openness towards these young markets.

Those excited to see his potential exit should be wary, as his successor may very well adopt a strong anti-crypto sentiment – something which could prove to be very harmful for a sector still in its infancy.

A Short Run

If opting to leave his post at the SEC, Clayton will have completed a roughly 3 year stint at its head.  So far, no word has been given on a possible successor as the Chairman of SEC.

For decades, the position of Chairman at the SEC has been a revolving door.  The last individual to serve longer than 4 years was Arthur Levitt, during the Clinton Administration.

CFTC

Word of Clayton’s potential replacement comes 1 year after the CFTC saw their very own chairman, J. Christopher Giancarlo, step down.  During their time spent at the helm of their respective organizations, both, Clayton and Giancarlo, were vocal on their approach towards blockchain.  While Clayton has remained more conservative, to this date, Giancarlo was viewed as more progressive and welcoming to change.

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Exchanges

OSC Finds Extensive Evidence of Fraud/Theft by Gerald Cotten and QuadrigaCX

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OSC Finds Extensive Evidence of Fraud/Theft by Gerald Cotten and QuadrigaCX

Over a year has passed since the demise of popular Canadian exchange, QuadrigaCX.  Despite this length of time, new findings are still being released surrounding the peculiar chain of events that saw $215 million go missing – a total representing the holdings of over 75,000 clients.

The Good

While the actions of Gerald Cotten and QuadrigaCX are, without doubt, a blight on the cryptocurrency industry, it is important to remember the old adage ‘do not paint with a broad brush’.

The OSC has, thankfully, recognized this, and taken the time to ensure readers that they are not condemning the sector as a whole, in their report.

“The misconduct we uncovered in relation to Quadriga is limited to Quadriga and should not be understood as applying to the crypto asset platform industry as a whole. Properly conducted, crypto asset trading is a legitimate and important component of our capital markets. We remain committed to working with this industry to foster innovation. Financial innovation has always been critical to the health of our economy and the competitiveness of our capital markets.”

The Bad

Now we move on to the bad.  After a thorough investigation, the OSC has determined that QuadrigaCX operated, essentially, as a Ponzi scheme underneath a ‘layer of modern tech’.  This Ponzi scheme is believed to be orchestrated by the late founder of QuadrigaCX, Gerald Cotten.

Furthermore, due to the custody model utilized by the exchange, the OSC believes QuadrigaCX to have been in consistent violation of securities laws.

“…whereby Quadriga retained custody, control and possession of its clients’ crypto assets and only delivered assets to clients following a withdrawal request—meant that clients’ entitlements to the crypto assets held by Quadriga constituted securities or derivatives.”

To this day, many of those affected by the debacle caused by Cotten have remained hopeful that the lost keys to his crypto wallets would be found.  This was due to a belief that these wallets contained much of the missing funds.  Unfortunately, the OSC has indicated that this is a fallacy.  Rather, the vast majority of missing funds were due to Cotten’s illegal trading activity.

 “It has been widely speculated that the bulk of investor losses resulted from crypto assets becoming lost or inaccessible as a result of Cotten’s death. In our assessment, this was not the case. The evidence demonstrates that most of the $169 million asset shortfall resulted from Cotten’s fraudulent conduct, which took several forms.”

If that wasn’t bad enough, the OSC concedes that, due to the circumstances (QuadrigaCX bankruptcy, and Cotten’s death), there exists very little room for recourse.

Financial Breakdown

In their report, the OSC notes that roughly $215 million is owed to QuadrigaCX customers.  They provide the following breakdown, shedding light on where the money has gone.

  • $115 million
    • Lost by Gerald Cotten through illegal trades on QuadrigaCX
  • $46 million
    • Recovered funds, now in the possession of a trustee
  • $28 million
    • Lost by Gerald Cotten through illegal trades on external exchanges
  • $23 million
    • Miscellaneous losses yet to be accounted for
  • $2 million
    • Funds stolen by Gerald Cotten to fund his lifestyle
  • $1 million
    • Operational losses

Whether through misappropriation, or illegal trades, the late Gerald Cotten is believed to be directly responsible for roughly $145 million lost in client funds.

Words of Warning

Throughout their report, the OSC doesn’t mince words when addressing companies still operating in the blockchain industry – Contact the OSC to see if registration is required under current laws.

They explicitly note, on multiple occasions, that securities laws apply in many instances, even when the traded assets are not securities.  The deciding factor comes down to how these assets are handled by exchanges.

“A platform would generally not be subject to securities legislation if the underlying crypto asset being traded is not a security or derivative, and there is immediate delivery of a crypto asset to the client after a transaction…In contrast, if a platform retains possession and control of the crypto assets being traded on the platform, securities law may apply.”

While this distinction may be small, it is an important one.  The OSC is imploring Canadian exchanges to reach out and determine where they fall within regulatory guidelines.

 “Platform operators should be aware that, depending on their business model, they may have to register with the OSC and they should take appropriate steps to comply with Ontario securities laws…Platforms should review their operations to ensure that they have procedures in place to manage risks to clients and that they are accurately disclosing key information about their operations to clients.”

OSC

The Ontario Securities Commission (OSC), is a regulatory body, tasked with ensuring fair and transparent markets.  This is done through the creation, and enforcement, of laws surrounding securities in the province of Ontario.

CEO, Grant Vingoe, currently oversees company operations.

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