1. Off-channel communications and message retention
SEC registrants that have failed to preserve “off-channel” messaging should strongly consider self-reporting immediately and improving their compliance programs. In December 2021, the SEC announced its first consent resolution – involving the imposition of a $125 million dollar penalty for a leading investment management company – based on that firm’s widespread record-keeping violations. Since then, the SEC has continued to aggressively pursue enforcement cases against registrants whose employees sent and received business-related communications through “off-channel” or unsupervised platforms. In the ensuing period, the SEC has issued detailed consent resolutions detailing that many registrants failed to preserve communications made through platforms such as personal email, SMS messaging, and other unsupervised communication channels such as WhatsApp and WeChat. As a result, the SEC concluded that registrants were not properly retaining records as required by SEC rules 17a-3 and 17a-4 and other record-keeping provisions.
Recent developments
While the SEC continues investigations and enforcement actions in this space, including issuing another $125 million dollar penalty against a major industry participant in 2023, in more recent matters, the SEC has also underscored the value of compliance, remediation, and self-reporting.
In September 2023, 10 registrants agreed to pay combined penalties of $79 million dollars and to conduct comprehensive reviews of their policies and procedures relating to the retention of off-channel communications. While certain respondents were assessed eight-figure penalties, one case was resolved with a $2.5 million dollar penalty, primarily because the respondents self-reported their violations. In relation to that matter, SEC Enforcement Director, Gurbir S. Grewal, noted that “[o]ne of the orders included in today’s announced actions is not like the others” and that “[t]here are real benefits to self-reporting, remediating, and cooperating.”
Likewise, in February 2024, 16 additional registrants agreed to pay combined penalties of more than $81 million dollars due to violations relating to the use of off-channel communications. Once again, although several registrants were assessed eight-figure penalties, one such case, once again, involved respondents who self-reported their violations and, as a result, were therefore only required to pay a $1.25 million dollar penalty. Again, Director Grewal stated that “one of these orders is not like the others: Huntington’s penalty reflects its voluntary self-report and cooperation.”
In addition to SEC enforcement actions, the Financial Industry Regulatory Authority (FINRA) has also brought enforcement actions against both its member firms and their associated persons for failing to retain off-channel communications. Notably, FINRA recently imposed a $10,000 penalty and a three-month suspension against a representative who improperly guaranteed a customer against losses using unsupervised text messages via his personal cell phone. Much like the SEC, FINRA highlighted the value of self-reporting regulatory violations in its 2024 annual regulatory oversight report.
What’s coming next
To date, respondents who have self-reported violations and taken affirmative steps toward compliance and remediation have received more favorable treatment by the SEC. Nonetheless, market participants with record-keeping obligations should anticipate that the SEC will continue aggressive investigatory sweeps and enforcement actions to identify and sanction additional and continuing violations.
Moreover, in its annual regulatory oversight report, FINRA reported findings, including that member firms (1) misinterpreted books and records obligations by failing to ensure their vendors’ ability to comply with record-keeping obligations, (2) failed to capture, review, and archive representatives’ electronic correspondence, including permitting the use of non-firm channels, and (3) failed to maintain the integrity of physical records that were converted to electronic records. In view of recent trends, we anticipate that FINRA will likely increase its efforts to investigate and bring cases against member firms and their associated persons for similar failures.
Accordingly, as regulators continue their investigatory and enforcement efforts to address the continuing use of off-channel business-related communications, industry participants should consider adopting affirmative steps to achieve compliance with their obligations. Individuals should discontinue the use of off-channel communications to conduct firm-related business and preserve any such communications. Firms would be wise to (1) enhance their surveillance efforts to identify the use of off-channel communications, (2) review and remediate prior use of such communications, and (3) consider self-reporting their findings when appropriate.
2. Expanded dealer definition
Recent developments
On February 6, 2024, the SEC adopted Final Rules that will significantly broaden the definitions of “dealer” and “government securities dealer” (together, the "Definitions") under sections 15 and 15C, respectively, of the Securities Exchange Act of 1934, as amended (the "Exchange Act"). The Final Rules come after almost two years of discussions between the Commission and industry participants.
The revised Definitions effectively broaden the SEC's regulatory gamut to define as a "dealer" any market participant that regularly engages in certain liquidity-providing activity in securities or government securities. Dealers are required to register with and report to the SEC and comply with the numerous laws, rules, and regulations that apply to financial institutions that deal in securities or tokenized assets. Applicable laws and regulations aim to offer investor protection, promote market integrity, and facilitate capital formation by setting minimum capital requirements and imposing strict regulatory reporting and recordkeeping obligations on dealers in securities and government securities. Dealers are further required to maintain membership in self-regulatory organizations such as FINRA, which frequently impose their own, further obligations on member firms.
According to the Commission's Adopting Release, the Definitions are meant to loop in proprietary trading firms, private funds and other intermediaries, including hedge funds and private equity funds, that provide significant, market-making liquidity to the markets but were traditionally excepted from SEC registration under section 3(a)(5) of the Exchange Act as persons that buy or sell securities for their own account and not as a part of "regular business" (commonly referred to as the "trader" exception). The Definitions also encompass high-speed trading and DeFi/algorithmic trading on blockchain, adding to the growing cost of compliance for fintechs and other entities in the U.S. digital and tokenized asset spaces.
In expressing his support for the Final Rules, SEC Chairperson Gary Gensler cited investor protection and "promoting market integrity, resiliency, and transparency." Chairperson Gensler also cited technological advancements as requiring the changes, noting the rise of electronification and algorithmic trading and highlighting the growing dominance of PTFs in the Treasury markets, which Chairperson Gensler called "de facto market makers."
What are the biggest changes made in the Final Rules?
- The Final Rules consider any person or entity that (1) owns or controls at least $50 million in total assets and is not a registered investment company, central bank, sovereign entity or international financial institution; and (2) regularly trades in securities (or government securities) for its own account to be trading “as part of a regular business” and required to register with and report to the SEC if its trades have the effect of providing liquidity to other market participants.
- The Final Rules outline two qualitative standards for trading activities to qualify as occurring “as part of a regular business": (1) regularly expressing trading interest that is at or almost at the best available market price for the same security on both sides of the market and that is also made accessible to other market participants; and (2) generating revenue mostly from (a) capturing bid-ask spreads, (b) buying at the bid price and selling at the offer price, or (c) taking advantage of trading venue incentives offered to liquidity-supplying interests. The "best available" market price is to be determined on a case-by-case basis based on the specific product or circumstance at hand.
- We note that the Final Rules do not include two of the SEC's most contested proposals for prongs in the “as part of a regular business” test, which would have added a qualitative standard to loop in entities that trade flat daily, as well as a quantitative test for entities that conduct large volume trades in government securities.
- Finally, the Final Rules further define the meaning of trading for one's “own account” to include any account held for the benefit of another person, but do not include the previously contemplated aggregation standard, which would have expanded the definition of “own account” to include accounts “held in the name of a person over whom that person exercises control or with whom that person is under common control.”
What’s coming next
Any person or entity that is newly required to be registered as a dealer in accordance with the Definitions must make a filing with the SEC within one year from the effective date of the Final Rules (60 days after their publication in the Federal Register).
3. Spot Bitcoin ETFs
Recent developments
Bitcoin has seen increased institutional adoption: with record-breaking inflows into recently launched U.S. Spot Bitcoin ETFs, the demand for stablecoins providing digital access to the U.S. dollar is soaring, and there has been an acceleration of engagement in the tokenization of real-world assets (fiat backed, U.S. Treasuries and other bonds, private credit, real estate). More products and bespoke structures are becoming available, and blockchain technology continues to integrate into traditional finance, sparking a resurgence of VC investment in crypto startups. Nevertheless, the industry continues to tread with cautious optimism as regulatory conditions remain in flux. We highlight a few of the key areas to look out for below.
Market
The bullish market sentiment that followed the initial launch of U.S. spot Bitcoin exchange-traded funds (ETF) largely remains, with Bitcoin up nearly 200% in the last year and reaching an all-time high price of over $73,000 before entering a milder corrective period, as predicted by numerous analysts and industry players, in which ETFs suffered a dip in inflows and a wave of outflows from the Grayscale Bitcoin Trust (GBTC). However, the U.S. disinflationary trend remains intact, and financial conditions are on track to continue easing, signaling a macro environment amenable to continued spot Bitcoin ETF inflows once GBTC selling is completed. As analysts at Coinbase Institutional have noted, however, the increased GBTC selling may be the result of Genesis's sales of shares as part of its bankruptcy process, and inflows to ETFs may well get back on track once Genesis's selloff is completed.
Regulatory
There is a growing acknowledgment that Chairperson Gensler’s SEC has been unfair in its legal approach to the crypto industry, which has repeatedly called for comprehensive regulations specific to decentralized protocols, including via litigation. The SEC's strategy of continuous, aggressive enforcement of laws that have yet to be established as definitively applicable to digital assets has been criticized by some as detracting value from the U.S. economy.
Most recently, the SEC has been rumored to be probing Ethereum’s native token, ether (ETH), and the Ethereum Foundation. The specifics of the investigation have not been disclosed but based on SEC precedent, potential subjects could include Ethereum’s initial coin offering, token distribution, and switch to a staking security model, although some have speculated that the SEC is seeking to classify ETH as a security as grounds to support a future denial of a spot ether ETF.
What’s coming next
We believe that the SEC is unlikely to be able to successfully support an enforceable characterization of ETH as security if it is indeed seeking to pursue this path, and that the path for mainstream adoption of digital assets continues to broaden. This is because it is the characteristics of a sale or transaction that make it an investment contract, rather than which cryptocurrency is being sold or exchanged. ETH is sold on public exchanges without advertising, and the SEC has previously approved ETH future ETF trading in the United States.
