On April 3, 2024, the Securities and Exchange Commission announced charges against a registered investment adviser for recordkeeping failures regarding personal device communications and pre-clearance of securities transactions in employees’ personal accounts. The firm was charged and agreed to pay a $6.5 million dollar penalty and to implement improvements to its compliance policies and procedures. Moreover, the adviser agreed to retain a compliance consultant to conduct reviews of its policies and procedures.

Facts

For almost two years, employees at all levels were found to be communicating about company business using personal texting platforms in violation of the firm’s policies and procedures. These off-channel communications were not preserved in the firm’s records as required by the Investment Advisers Act of 1940 (“Advisers Act”). In a specific instance, a group of employees communicated on a system that was programmed to delete their messages automatically after 30 days. Additionally, the adviser failed to enforce their code of ethics requiring pre-clearance for all securities transactions in employees’ personal accounts. The regulatory basis for the SEC’s charges stems from the firm’s failure to supervise and prevent violations of the recordkeeping rule and certain ethics provisions of the Advisers Act.

The attorneys at Stark & Stark remain available to assist.

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Background

On March 18, 2024, the Securities and Exchange Commission announced settled charges against two SEC registered investment advisers for making false and misleading statements about their purported use of artificial intelligence (“AI”). The firms agreed to settle the SEC’s charges and pay $400,000 in total civil penalties.

Cause of Action

One firm’s charges arose from four years of using misleading statements pertaining to its use of AI in its SEC filings, press releases, and website. They claimed to have used AI to generate an advantage in their investment process, but they did not have such resources. Additionally, these statements were also deemed a violation of the marketing rule. The second firm was also found to have violated the marketing rule and its AI misconducts were born from using the term “expert AI driven forecasts.”

What’s Next

These settlements come on the heels of the SEC proposed rules in July 2023 regarding investment advisers use of AI. The July rules would prohibit investment advisers from using AI in a manner that creates a conflict of interest between a firm and its client. Specifically, investment advisers would need to adopt policies and procedures regarding their use of AI. Advisers would also need to comply with recordkeeping requirements consisting of times the technology was implemented or materially changed.

Before using or marketing AI, advisers should consult legal counsel. Contact our Investment Management & Securities attorneys if you have any questions!

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On February 13, 2024, the U.S. Department of Treasury’s Financial Crimes Enforcement Network (FinCEN) proposed a rule to combat criminals and foreign adversaries from exploiting the U.S. financial system through investment advisers (the “FinCEN Rule”). The FinCEN Rule will add system transparency and help law enforcement identify risks from anonymous companies and all-cash real estate transactions. The proposed Rule would force SEC registered investment advisers and exempt reporting advisers to implement risk-based Anti-Money Laundering and Countering the Financing of Terrorism (AML/CFT) programs. The programs would require advisers to report suspicious activity to FinCEN and to maintain accurate records. Investment advisers would be classified as “financial institutions” under the Bank Secrecy Act (“BSA”). FinCEN is proposing to delegate examination authority for this Rule to the SEC.

The proposed FinCEN Rule would require SEC registered investment advisers and exempt reporting advisers to:

• implement an AML/CFT program;
• file certain reports, such as Suspicious Activity Reports (SARs), with FinCEN;
• keep records such as those relating to the transmittal of funds (i.e., comply with the Recordkeeping and Travel Rule); and
• fulfill other obligations applicable to financial institutions subject to the BSA and FinCEN’s implementing regulations.

The proposed rule would apply information sharing between and among FinCEN, law enforcement government agencies, and certain financial institutions to investment advisers, along with subjecting investment advisers to the “special measures” imposed by FinCEN pursuant to Section 311 of the USA PATRIOT Act. At this time, there is no customer identification requirement for investment advisers under the Rule. FinCEN and the SEC intend to implement a customer identification program in the future. Likewise, the subjected investment advisers do not need to collect beneficial ownership information for legal entity customers. The proposed Rule would not require investment advisers to apply the AML/CFT program or SAR filing requirements to mutual funds they advise.

Under the proposed rule, covered investment advisers would be required to comply with the rule on or before 12 months from the final rule’s effective date. The comment period for the Rule is open until April 15, 2024.

The Investment Management & Securities attorneys at Stark & Stark will continue to monitor the proposed new Rule.

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The SEC approved eleven spot Bitcoin ETFs on January 10, 2024. As a result, investment advisers may be curious about whether or how to integrate Bitcoin ETFs into client portfolios. This blog is intended to provide an update on the regulatory landscape and inform advisers how to fulfill their compliance obligations if they determine these assets should be integrated into client portfolios.

Please Note: This blog is not, and does not serve as, an endorsement of Bitcoin, or any other cryptocurrency. Advisers must separately educate their investment professionals and clients about cryptocurrencies prior to integrating crypto into client portfolios or assisting with a client directed purchase.

Summary

Bitcoin is considered to be speculative. The SEC has been aggressively reviewing cryptocurrency investments during examinations. Depending upon the scope of an adviser’s assistance with/use of Bitcoin or cryptocurrencies (employing same as a courtesy/client directed accommodation vs. utilizing same as an asset class in client portfolios) both applicable clear and conspicuous ADV disclosure, and a separate Acknowledgment executed by the client, are strongly encouraged. We continue to assist our clients with such disclosures/acknowledgements.

Spot Bitcoin ETF Approval

On January 10, 2024, the SEC approved eleven spot Bitcoin ETFs. The ETFs, from financial behemoths like BlackRock, Fidelity, WisdomTree, and Invesco, began trading on January 11, 2024. With approval of a spot Bitcoin ETF, investment advisers should be prepared to consider a spot Bitcoin ETF to client portfolios. However, doing so comes with compliance implications, and it is critical for advisers to conduct robust due diligence to ensure such integration is reasonable and suitable for clients.

Compliance Program

Investment advisers registered at the federal and state level are required to maintain a robust compliance program. Advisers who want to integrate a spot Bitcoin ETF should update their policies and procedures manual to address the unique risks and challenges that these assets present, including:

Suitability – prior to purchasing a spot Bitcoin ETF for clients, advisers should ensure that these assets are suitable for the client. Bitcoin is historically (and notoriously) volatile, and advisers should assess whether an investment in Bitcoin aligns with a client’s suitability, long-term objectives, and risk tolerance.

Disclosures and Acknowledgements – advisers should provide clients with an acknowledgement form wherein the client acknowledges the risks associated with purchasing a spot Bitcoin ETF and that the asset class is currently considered speculative. Additionally, advisers may update Form ADV Part 2A to include language which similarly describes the risks associated with Bitcoin and how the adviser integrates it into a client’s portfolio (i.e., on a discretionary basis or at specific client direction). Stark & Stark remains available to assist with preparing the acknowledgement and, when necessary, appropriate ADV disclosure language.

Fiduciary Duty

Registered investment advisers are fiduciaries and are required to act in the best interests of their clients. With this power comes the responsibility to:

• Conduct thorough due diligence, including understanding Bitcoin’s market dynamics, its correlation with other assets, and the technology behind it, and appropriately educate firm employees on these market dynamics; and
• Educate clients and ensure clients understand the risks and potential rewards of investing in Bitcoin.

Transparency About Fees

Purchasing a Bitcoin ETF may come with fees. For example, as of writing, spot Bitcoin ETFs have fees ranging from 0% to 1.50% based on various factors. If an adviser charges fees associated with the acquisition, management, or disposition of a Bitcoin ETF, it is crucial to be transparent. Advisers should clearly disclose any associated fees in their investment advisory agreement and ensure such fees are reasonable in light of the services provided.

Conclusion

The SEC’s approval of a spot Bitcoin ETF is a testament to Bitcoin’s growing legitimacy as an asset (however, as indicated above, this blog is not, and should not be construed in any manner whatsoever as, an endorsement of Bitcoin or any other cryptocurrency investment). As Bitcoin’s institutional legitimacy grows, integrating Bitcoin exchange traded products into client portfolios can put advisers at the forefront of the new financial revolution. However, integrating Bitcoin into client portfolios comes with compliance obligations. By adhering to a robust compliance framework, keeping abreast of regulatory changes, and educating themselves and clients on the benefits of Bitcoin, advisers can harness the potential of Bitcoin while fulfilling their fiduciary and compliance obligations.

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Bitcoin and other Cryptocurrencies

With recent developments in the regulatory, legal, and compliance landscape surrounding Bitcoin and a spot Bitcoin ETF (i.e., an ETF backed by physical Bitcoins. If the value of the digital coins backing the ETF rises, the value of the investment will generally be expected to increase), some investment advisers may be considering how to potentially integrate Bitcoin (and/or other types of cryptocurrencies) into client portfolios. This Alert is intended to provide an update on the regulatory landscape and inform advisers how to fulfill their compliance and fiduciary obligations should they determine to integrate Bitcoin (specifically, the current GBTC (see below) and/or anticipated ETFs that will invest in Bitcoin or other types of cryptocurrencies) into client portfolios or assist a client with a requested purchase thereof. Please Note: This Alert is not, and does not serve as, an endorsement of Bitcoin, or any other cryptocurrency. Advisers must separately educate their investment professionals and clients about cryptocurrencies prior to integrating crypto into client portfolios or assisting with a client directed purchase.

Summary

Bitcoin is considered to be speculative. The SEC has been aggressively reviewing cryptocurrency investments during examinations. Depending upon the scope of an adviser’s assistance with/use of crypto (employing same as a courtesy/client directed accommodation vs. utilizing same as an asset class in client portfolios) both applicable clear and conspicuous ADV disclosure, and a separate Acknowledgment executed by the client, are strongly encouraged-we continue to assist our clients with such disclosures/acknowledgements.

Regulatory Landscape

On August 29, 2023, the United States Court of Appeals of the D.C. Circuit ruled in favor of Grayscale Investments in Grayscale’s lawsuit against the SEC for denying the company’s application to convert its Grayscale Bitcoin Trust (GBTC) into a spot Bitcoin ETF. The Court’s ruling vacated an order by the SEC denying Grayscale’s spot Bitcoin ETF application and requires the SEC to consider the application anew.

The ruling could have far-reaching implications for other spot Bitcoin ETF applications. As of August 30, 2023, the SEC is considering 14 spot Bitcoin ETF applications, including applications from financial behemoths like BlackRock, WisdomTree, and Invesco, to name a few. Analysts have predicted that odds of spot Bitcoin ETF approval are 75% in 2023 and 95% in 2024. With the imminent approval of a spot Bitcoin ETF, investment advisers could determine to consider adding a Bitcoin ETF to client portfolios. However, doing so comes with compliance implications, and it is critical for advisers to conduct appropriate due diligence to confirm that such integration is reasonable and suitable for clients.

Compliance Program

Investment advisers registered at the federal and state level are required to maintain a robust compliance program. Advisers who want to integrate a Bitcoin (or other type of crypto) ETF should update their policies and procedures to address the unique risks and challenges that Bitcoin presents, including:

• Suitability – prior to proactively (vs. only per client request/direction) purchasing a Bitcoin ETF for clients, advisers should confirm that these assets are suitable for the client. Bitcoin is historically (and notoriously) volatile, and advisers should assess whether an investment in Bitcoin (or any other type of cryptocurrency) is consistent with a client’s suitability, long-term objectives, and risk tolerance.
• Disclosures and Acknowledgements – advisers should request that clients execute an Acknowledgement which, among other disclosures, makes clear that cryptocurrencies are considered to be speculative investment, and that unlike conventional currencies issued by a monetary authority, currently, cryptocurrencies are generally not controlled or regulated, and their price is determined by the supply and demand of their market. Additionally, those advisers who are considering proactively incorporating crypto into client portfolios should amend their Brochure (i.e., Form ADV Part 2A) to include language that similarly describes the risks associated with Bitcoin and how the adviser can integrate crypto into a client’s portfolio (i.e., on a discretionary/non-discretionary basis, or at specific client direction). Stark & Stark can assist with preparing the acknowledgement and appropriate ADV disclosure language.

Fiduciary Duty

Registered investment advisers are fiduciaries and are required to act in the best interests of their clients. As such, comes the responsibility to:

• Conduct thorough due diligence, including understanding bitcoin’s market dynamics, its correlation with other assets, and the technology behind it;
• Educate clients so that they can better understand both the risks and potential rewards of investing in Bitcoin (or any other cryptocurrencies); and,
• Disclose the fees associated with such an investment (i.e., both the underlying investment’s fees and the adviser’s fee).

Conclusion

The D.C. Circuit’s ruling on Grayscale’s spot ETF application, and the SEC’s currently anticipated approval of a spot ETF, reflects Bitcoin’s growing legitimacy as an asset (however, as indicated above, this Alert is not, and should not be construed in any manner whatsoever as, an endorsement of Bitcoin or any other cryptocurrency investment). However, integrating Bitcoin into client portfolios comes with compliance obligations. By adhering to a robust compliance framework, keeping abreast of regulatory changes, and educating themselves and clients on the both the risks and benefits of Bitcoin, advisers can seek to harness the potential of Bitcoin while fulfilling their fiduciary and compliance obligations.

The attorneys at Stark & Stark remain available to assist.

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The Department of Labor (“DOL”) rule requirement continues with the fast-approaching filing date for an investment adviser’s initial Retrospective Review. While we anticipate assisting many investment advisers with their completion of this new requirement, it is important to understand its purpose and components. For this reason, I asked our colleague, Joseph Antonakakis, to share his expertise.

The Retrospective Review (the “Review”) requirement of Prohibited Transaction Exemption 2020-02 (the “PTE”) is designed to assist in detecting and preventing violations of, and achieving compliance with, the Impartial Conduct Standards and the policies and procedures adopted for compliance with the PTE. Compliance with the standards of the PTE is achieved by:

• Providing investment advice that is in the retirement investor’s best interest,
• Charging reasonable compensation,
• Avoiding materially misleading statements about the recommended investment transaction and other relevant matters,
• Seeking to obtain the best execution of the investment transaction reasonably available under the circumstances, as required by the federal securities laws, and
• Self-correcting any violation within 90 days and furnishing notification to the DOL within thirty days of the correction.

Purpose of the Review

The DOL expects advisers to use the results of the review to find more effective ways to help ensure that investment professionals are providing investment advice in accordance with the Impartial Conduct Standards and to correct any deficiencies in existing policies and procedures. Senior executive officers, such as the investment adviser’s Chief Compliance Officer should carefully review the report before making the required certifications, so that they can make the certifications with confidence. This ensures that the investment adviser, through an appropriate executive officer, is fully accountable for the retrospective review.

Activities and Transactions Covered

Advisers’ recommended transactions that must be reviewed under the Retrospective Review include ensuring the investment adviser follows the best interest standard of care, receives only reasonable compensation and satisfying the SEC’s best execution standard, not making materially misleading statements related to recommendations, making required disclosures prior to engaging in a recommended transaction, establishing and enforcing policies and procedures, and completing the Retrospective Review Report.

Timing

The retrospective review, report and certification must be completed at least annually and no later than six months following the end of the period covered by the review. A review covering calendar year 2022 must be completed by or before July 1, 2023. The investment adviser must retain the report, certification and supporting data for six years and provide these documents to a DOL or Internal Revenue Service official within 10 business days of a request.

Written Report

The methodology and results of the retrospective review must be reduced to a written report. The written report must:

• Describe the policies and procedures in place at the investment adviser which ensure compliance with the requirements of the Impartial Conduct Standards, violations of the investment adviser’s compliance policies and procedures during the review period;
• Describe violations of the investment adviser’s compliance policies and procedures during the review period, including a description of the issue, how the issue was detected, and how the issue was remediated;
• Whether any self-corrections were required, as discussed further below; and
• How the policies and procedures were modified, if at all.

The written report should be provided to one of the investment adviser’s Senior Executive Officers, who must then make certain certifications related to their review of the report, including:

• The Senior Executive Officer has reviewed the report of the retrospective review;
• The Financial Institution has in place policies & procedures prudently designed to achieve compliance with the conditions of the exemption; and
• The Financial Institution has in place a prudent process to modify such policies and procedures as business, regulatory, and legislative changes and events dictate, and to test the effectiveness of such policies and procedures on a periodic basis, the timing and extent of which is reasonably designed to ensure continuing compliance with the conditions of the exemption.

Self-Correction and Reporting

Violations of the PTE’s conditions can be self-corrected when conducting the retrospective review.

Section II(e) of the PTE contains a self-correction procedure for investment advisers to correct certain violations. Investment advisers can correct violations of the exemption within 90 days after the investment adviser learns, or reasonably should have learned, of the violation. If the violation did not result in investment losses to the retirement investor or if the investment adviser made the retirement investor whole for any resulting losses, the investment adviser must correct the violation and notify the Department of Labor at IIAWR@dol.gov within 30 days of correction. The investment adviser must notify the persons responsible for conducting the retrospective review of the violation and correction, and the violation and correction must be specifically set forth in the written report of the retrospective review.

The Department believes that the self-correction provision will provide Financial Institutions with an additional incentive to take the retrospective review process seriously, timely identify and correct violations, and use the process to correct deficiencies in their policies and procedures, so as to avoid potential future penalties and lawsuits.

Because we anticipate a substantial demand for our assistance with this new requirement, please advise us, via responsive email to tdg@stark-stark.com, if you would like our assistance. We will confirm receipt of your request, and you will be included on our Retrospective Review list. Thereafter, we will commence assisting investment advisers with their initial Retrospective Review in April (subsequent to the pending 3/31/23 annual ADV amendment deadline).

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