Securities Industry Commentator by Bill Singer Esq

[F]rom December 2009 through May 2014, Rider defrauded five victims by falsely stating that an individual in Mexico, named Patricia, was in danger and needed assistance to travel to the United States.  Rider falsely stated that once "Patricia" was safely in the United States, she would have access to money to repay the victims.

Based on Rider's false statements, the victims provided her with approximately $1,285,545.01, which she used at casinos and elsewhere for her personal benefit.  As a result of the fraud, some elderly victims lost their retirement savings.

Market participants have raised questions concerning the application of the federal securities laws and the rules of the Financial Industry Regulatory Authority ("FINRA") to the potential intermediation-including custody-of digital asset securities and transactions.  In this statement, the staffs of the Division of Trading and Markets (the "Division") and FINRA (collectively, the "Staffs")-drawing upon key principles from their historic approach to broker-dealer regulation and investor protection-have articulated various considerations relevant to many of these questions, particularly under the SEC's Customer Protection Rule applicable to SEC-registered broker-dealers.

As a threshold matter, it should be recognized by market participants that the application of the federal securities laws, FINRA rules and other bodies of laws to digital assets, digital asset securities and related innovative technologies raise novel and complex regulatory and compliance questions and challenges.  For example, and as discussed in more detail below, the ability of a broker-dealer to comply with aspects of the Customer Protection Rule is greatly facilitated by established laws and practices regarding the loss or theft of a security, that may not be available or effective in the case of certain digital assets.

Considerations for Broker-Dealer Custody of Digital Asset Securities

Whether a security is paper or digital, the same fundamental elements of the broker-dealer financial responsibility rules apply.  The Staffs acknowledge that market participants wishing to custody digital asset securities may find it challenging to comply with the broker-dealer financial responsibility rules without putting in place significant technological enhancements and solutions unique to digital asset securities.  As the market, infrastructure, and law applicable to digital asset securities continue to develop, the Staffs will continue their constructive engagement with market participants and to gather additional information so that they may better respond to developments in the market[10] while advancing the missions of our respective organizations: for the SEC, to protect investors; maintain fair, orderly, and efficient markets; and facilitate capital formation; and for FINRA, to provide investor protection and promote market integrity.

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Considerations for Digital Asset Securities

There are many significant differences in the mechanics and risks associated with custodying traditional securities and digital asset securities.  For instance, the manner in which digital asset securities are issued, held, and transferred may create greater risk that a broker-dealer maintaining custody of them could be victimized by fraud or theft, could lose a "private key" necessary to transfer a client's digital asset securities, or could transfer a client's digital asset securities to an unknown or unintended address without meaningful recourse to invalidate fraudulent transactions, recover or replace lost property, or correct errors.  Consequently, a broker-dealer must consider how it can, in conformance with Rule 15c3-3, hold in possession or control digital asset securities.

In particular, a broker-dealer may face challenges in determining that it, or its third-party custodian, maintains custody of digital asset securities. If, for example, the broker-dealer holds a private key, it may be able to transfer such securities reflected on the blockchain or distributed ledger.  However, the fact that a broker-dealer (or its third party custodian) maintains the private key may not be sufficient evidence by itself that the broker-dealer has exclusive control of the digital asset security (e.g., it may not be able to demonstrate that no other party has a copy of the private key and could transfer the digital asset security without the broker-dealer's consent).  In addition, the fact that the broker-dealer (or custodian) holds the private key may not be sufficient to allow it to reverse or cancel mistaken or unauthorized transactions.  These risks could cause securities customers to suffer losses, with corresponding liabilities for the broker-dealer, imperiling the firm, its customers, and other creditors.

1. From December 2015 to November 2017, Aquino, then a registered representative at a broker-dealer based in New York City, engaged in a fraud involving excessive trading in the accounts of his retail customers that generated substantial commissions to enrich himself while his customers experienced significant losses. 

2. Aquino persuaded at least seven customers to maintain securities trading accounts with him at the firm and assured them that he would employ a profitable trading strategy on their behalf. Aquino recommended a series of frequent, short-term trades to these customers while charging them costly commissions and fees for each trade. The frequency of Aquino's trading, coupled with the commissions and fees on every trade, made it almost certain that his customers would lose money from the recommended level of trading. Indeed, the customers' investments would need to achieve annual returns of approximately 21% to 406% just to pay for the transaction costs associated with Aquino's trading strategy. 

3. Aquino was required to have a reasonable basis to believe his trading strategy was suitable for the customers to whom he recommended it. In fact, Aquino did not have a reasonable basis to believe that the frequent level of trading he recommended to customers, given the significant costs imposed on them, would be suitable for them or anyone else. Additionally, Aquino recommended a level of trading that was unsuitable to six customers, in light of those customers' financial needs, investment objectives, risk tolerance, and other circumstances. Aquino also engaged in fraudulent and deceptive conduct by executing certain trades in customers' accounts without first obtaining their approval or informing them of material facts about the trading strategy he recommended, as required for non-discretionary accounts. 

4. Aquino violated the antifraud provisions of the federal securities laws by: (a) recommending an investment strategy to his customers without a reasonable basis to believe it was suitable for those investors; (b) recommending an investment strategy that was unsuitable for certain of his customers in light of those customers' financial needs, investment objectives, and circumstances; (c) making materially false and misleading statements to customers regarding the strategy; and (d) engaging in unauthorized trading. 

5. Aquino's fraudulent acts and omissions resulted in approximately $881,000 in losses for the customers and $935,000 in ill-gotten gains for Aquino. 

[S]ince we adopted our rulemaking package, there has been no shortage of views expressed, both from those in support of our efforts and from those who would have preferred a different approach. Some of this commentary has, in my view, shown a lack of understanding of the law and legal obligations of financial professionals, both before and after adoption of our rulemaking package. This has only further solidified my view that our actions were timely and appropriate, and will ultimately benefit retail investors and our markets.

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Let me now address some of the commentary, or, more specifically, the criticism and misinformation, I alluded to at the outset. I believe that much of this criticism-which is focused broadly on the extent of the investor protections under Reg. BI and our Fiduciary Interpretation-is false, misleading, misguided, and unfortunately, in some cases, is simply policy preferences disguised as legal critiques.

Before discussing specific points, I want to address a general issue-whether it is appropriate to maintain a regulatory distinction between broker-dealers and investment advisers. A number of commenters expressly or impliedly advocated for regulation that would collapse the distinction, with a substantial majority of those commentators favoring the generally applicable investment adviser model where clients pay an asset-based fee or a flat fee for generally broad-based financial advice from a fiduciary. To be clear, I believe this is a good model, and for many investors, this type of investment adviser relationship may better match their needs than the typical broker-dealer relationship. However, for many other investors, the broker-dealer model, particularly after the implementation of Reg. BI-either alone or in combination with an investment adviser relationship-provides the better match. For example, a retail customer that intends to buy and hold a long-term investment may find that paying a one-time commission to a broker-dealer is more cost effective than paying an ongoing advisory fee to an investment adviser to hold the same investment. That same investor might want to use a brokerage account to hold those long-term investments, and an advisory account for other investments.

This is a key reason why one of our goals in this rulemaking was to preserve access and choice for Main Street investors. I firmly believe that as a result retail investors will be better off-choice and competition will ultimately inure to the benefit of retail investors in terms of lower fees, better services and transparency, and more offerings.

Under our approach, Main Street investors will be able to choose the type and level of services they want-from occasional recommendations about particular investments to comprehensive account management-and how they want to pay for those services. I do not believe that a "one size fits all" approach would best serve the diverse interests of our Main Street investors. Further, I believe in this area, a one-size fits all approach could reduce the availability and increase the cost of advice and services, particularly for those with relatively smaller accounts.

• Securities Industry Commentator
• Bill Singer