On March 9, 2022, President Biden signed Executive Order 14067 outlining the federal government’s strategy on ensuring the responsible development of digital assets.
The Executive Order laid out six objectives:
The Executive Order’s measures, specifically on consumer and investor protection, is a call-to-action for federal agencies such as the Securities & Exchange Commission (and by extension, FINRA), to ensure sufficient oversight and safeguards against risks imposed by digital assets.
Digital asset risks not only come from foreign trading platforms, unscrupulous promoters, and bad actors, but investors can encounter dangers from their very own brokerage firms.
For those who do not know, a “digital asset” refers to cryptocurrencies and other virtual coins, tokens, and any other asset that consists of, or is represented by, records in a blockchain or distributed ledger.
This includes any securities, commodities, software, contracts, accounts, rights, intangible property, personal property, real estate or other assets that are “tokenized,” “virtualized” or otherwise represented by records in a blockchain or distributed ledger.
In the financial world, companies and individuals are trying to capitalize on the excitement surrounding blockchain and the promise of digital assets.
In Section 5 (b)(vi) of his Executive Order, President Biden encourages SEC Chair Gary Gensler to consider the extent to which investor protections may be used to address the risk of additional assets and whether additional measures may be needed. That evaluation has been ongoing for several years at the SEC and FINRA, and one of FINRA’s recent reports provides helpful guidance to investors about the perils they (unwittingly) face from their own brokerage firms when it comes to digital assets.
For instance, in February 2022, FINRA released its 2022 Report on its Examination and Risk Monitoring Program. The Report provides firms with information that may help inform their compliance programs through, among other things, summarizing noteworthy findings from recent examinations, outlining effective practices that FINRA observed during its oversight, and giving additional resources that may be helpful to member firms in reviewing their supervisory procedures and controls and fulfilling their compliance obligations. Viewed through the lens of an investor, the Report gives a useful roadmap of the perils and risks retail customers face from broker-dealers, especially for those investing perils involving digital assets.
FINRA’s most recent Report found deficiencies in broker-dealer’s review and recordkeeping of outside business activities involving digital assets.
The relevant rules on this matter – FINRA Rules 3270 (Outside Business Activities of Registered Persons) and 3280 (Private Securities Transactions of an Associated Person) – require registered representatives to notify their firms in writing of proposed outside business activities. The rules require all associated persons to notify their firms in writing of proposed private securities transactions so firms can determine whether to limit or allow those activities. A firm approving a private securities transaction where the associated person has or may receive selling compensation must record and supervise the transaction as if it were executed on behalf of the firm.
As FINRA notes in its Examination Report:
FINRA’s examination revealed that broker-dealers were failing to conduct the required assessment of outside business activities that involve digital assets or incorrectly assuming all digital assets are not securities and therefore, not evaluating digital asset activities, including activities performed through affiliates, to determine whether they are more appropriately treated as private securities transactions. For certain digital asset or other activities that were deemed to be private securities transactions for compensation, broker-dealers were failing to supervise such activities or recording such transactions on the firm’s books and records (emphasis added).
Messaging matters. Unsurprisingly, FINRA Rule 2210 (Communications with the Public), which governs the approval, review and recordkeeping of a broker-dealer’s communications and correspondences, including communications to retail customers, is one of FINRA’s main focuses in protecting investors from digital asset risks.
In its 2022 Report, FINRA poses two questions to member firms who engage in, or their affiliates engage in, digital asset activities:
As it turns out, investors are not understanding digital asset risks or the brokerage firm’s services when it comes to digital assets. For instance, FINRA found that there are deficient communications concerning digital assets and broker-dealers. Specifically, FINRA found that communications were falsely identifying the broker-dealer as the entity from whom digital assets may be purchased or creating confusion about which entity is offering digital assets by using identical or substantially similar names to the broker dealer’s name. As Reuters reported in January 2022, FINRA is aiming to strengthen disclosures for broker dealers that sell digital assets.
Further, in addressing the digital asset communication deficiencies, FINRA laid out effective practices for broker-dealers that also provide helpful advice to investors. Specifically, investors should be wary of, among other things, exaggerated potential benefits of digital assets and understand what products and services are being offered by broker-dealers.
Despite the prevalence of investor fraud in the space, digital asset risks can be mitigated through some due diligence, especially in interactions with brokerage firms:
KlaymanToskes is a leading national securities law firm practicing exclusively in the field of securities arbitration on behalf of retail and institutional investors throughout the world in large and complex securities matters. KlaymanToskes has recovered more than $230 million for investors in FINRA arbitrations. KlaymanToskes has office locations in California, Florida, New York, and Puerto Rico.