Electronic and Remote Examinations Continue Amid Coronavirus Containment Efforts.
Crowell & Moring and Silver Regulatory Associates recently gathered counsel and compliance professionals from the private fund industry for a lively roundtable discussion on the hot button issues outlined in the SEC’s 2020 Exam Priorities. The discussion and key insights on the topic are summarized below.
While the SEC may be limiting onsite exams for the time being due to coronavirus containment efforts, we have seen a general uptick in electronic and remote exams. It is imperative, even amid market volatility and uncertainty, for funds to remain diligent in their approach to regulatory compliance.
Maintaining its primary focus on investor protection, the SEC has noted increased risks for retail investors arising from the digital asset space. Michelle Gitlitz, global head of Crowell & Moring’s Blockchain and Digital Assets Practice, noted: “Whether you are a registered broker-dealer, operating a currency exchange and exempt from registration, or a private fund that is investing in digital or cryptocurrency assets, regulators are looking at you. Since laws were written at a time when we weren’t even anticipating this technology, digital asset businesses are having to navigate a very complex regulatory and compliance landscape.”
Fizza Khan, CEO of outsourced compliance firm Silver Regulatory Associates added: “Many of the exam priorities the OCIE has outlined are true among all strategies, however it’s imperative to understand which also apply to digital assets.”
Michelle, Fizza and Carlton Greene, partner in Crowell & Moring’s International Trade and White Collar & Regulatory Enforcement groups, highlighted the following SEC exam priorities as most applicable to digital asset managers:
- Investment Suitability – First and foremost, the SEC wants to determine whether digital assets are the right type of investment for the manager’s investor base. A firm’s investor materials must include an explanation of the digital assets and different types of token and disclosure of the risks associated with investing in digital assets.
- Portfolio Management and Trading Practices – In preparing for a routine or surprise SEC exam to occur at any moment, firms must ensure thorough and detailed documentation of the investment strategy and processes. This may include identification of digital assets in the portfolio, with data and research used to determine digital allocations. Be mindful of alerting investors of any changes in portfolio strategy in a timely and transparent manner.
- Safety of Client Funds and Assets – The Custody Rule continues to be an area of focus for the SEC, and can be tricky as it relates to digital assets. Since the space is still developing, how do you determine a qualified custodian? Is the concept of “self-custody” for lack of qualified custodians in the digital asset space viable with the SEC? It’s important to understand how the Custody Rule applies to blockchain technology and how to comply with the Rule’s requirements to verify the assets of a fund through a qualified custodian.
- Pricing and Valuation – One of the first things the SEC wants to look at when examining any manager is policies and procedures around the valuation of securities. Pricing and valuation of digital assets can be marked to market for publicly traded digital assets, but those assets that are private or illiquid may be difficult to valuate. In this case, the same fundamentals that are used to assess any type of asset portfolio should be applied.
- Anti-Money Laundering (AML) Risks for Digital Assets – “Regardless of if you are a registered broker-dealer or not, when it comes to AML compliance, if you are doing any type of digital currency exchange, regulators look at everyone the same,” said Carlton. AML penalties are very popular with not just the SEC, but FINRA, the DOJ and other U.S. and foreign regulators. Areas of focus are: customer identification, SARs filings, beneficial ownership and periodic independent audits.
- Effectiveness of Compliance Programs and Controls – Keep your house in order. Whether using an internal team or outsourcing compliance, the best way to ensure a smooth SEC exam is to have proper internal compliance controls and protocols in place that are customized to address risks associated with digital strategies. Communicate and train on these policies and procedures, as well as develop and promote a Code of Ethics and policy around conflicts of interest.
While there is still much complexity and not a one-size-fits-all approach to navigating this new regulatory territory, the SEC always requires transparency and clear and consistent reporting. By putting in place institutional-quality processes, and not being afraid to call upon experienced external compliance and legal counsel, digital firms can ensure a smooth routine exam process.