Crypto-Focused Private Fund Adviser Settles with U.S. SEC for Custody Rule and Other Violations

On September 3, 2024, the U.S. Securities and Exchange Commission charged a former registered investment adviser for failing to ensure that certain “crypto assets that were offered and sold as securities” held by its private fund client were maintained with a qualified custodian, as required by Rule 206(4)-2 of the Investment Advisers Act of 1940, referred to as the “Custody Rule.”¹ According to the SEC’s order, the adviser maintained certain of the fund’s “crypto asset securities” in accounts on digital asset trading platforms that were not qualified custodians — in particular, FTX Trading Ltd. The fund lost approximately half of its assets in the wake of FTX’s collapse. The SEC also charged the adviser with misleading investors about redemption periods and compliance failures. The adviser agreed to a US$225,000 penalty to settle the charges, to be distributed to fund investors impacted by the Custody Rule violation.

This is the first SEC enforcement action involving Custody Rule violations related to digital assets, an issue that has long been, and will continue to be, a focus of the SEC.

The SEC’s Enforcement Action

Galois Capital Management LLC (Galois) advised a fund that, according to the SEC’s order, held certain unspecified “crypto assets that were offered and sold as securities,” which the order referred to as “crypto asset securities.” Galois continuously held those assets in accounts on digital asset trading platforms, including FTX, which the SEC found were not “qualified custodians” under the Custody Rule. The order notes that the fund lost approximately half of its assets under management in connection with the collapse of FTX.

The Custody Rule requires investment advisers registered or required to be registered with the SEC who have custody of client funds or securities to comply with specific requirements that are intended to safeguard those assets from loss, theft, misuse, or misappropriation and to protect client funds and securities from financial reverses of the adviser, including insolvency. Among other requirements, the adviser must ensure that such assets are maintained by a “qualified custodian,” which the Custody Rule defines to mean certain banks, broker-dealers, futures commission merchants, and foreign financial institutions.

In addition to asserting a violation of the Custody Rule, the SEC’s order also charged Galois with misleading investors about the notice period required for redemptions. Specifically, the order found that although the fund’s limited partnership agreement (LPA) required 30 days’ written notice (absent approval by the general partner), Galois had an informal practice of permitting redemptions with shorter notice periods — at least five days and in some instances even less — by affiliated and unaffiliated investors, which Galois communicated only to certain investors. The SEC’s order found that Galois’s failure to disclose its redemption practices to all investors rendered the LPA disclosures materially misleading.

Finally, the SEC charged Galois with generally failing to adopt or implement written policies and procedures reasonably designed to prevent Advisers Act violations while it was a registered investment adviser.

To settle the matter, Galois agreed to pay a civil monetary penalty of US$225,000 and the expenses associated with administering a Fair Fund that will be established to distribute the penalty to outside investors impacted by the failure to maintain certain of the “crypto asset securities” at a qualified custodian.

Takeaways

The action comes after years of SEC registrant examinations and a more recent industry-wide investigative sweep concerning Custody Rule compliance for digital asset investments, as well as numerous and ongoing SEC actions over whether digital asset offers and sales constitute securities. The action also comes after a still-pending February 2023 proposal to expand the Custody Rule to bring within its scope a broader range of investments, including digital assets, whether or not the investments are securities.² While the structural complications in navigating the Custody Rule for digital assets are not news to the SEC, it has selected a high-profile case with real client harm to bring the first enforcement action on this topic. In an associated press release, Corey Schuster, Co-Chief of the SEC Enforcement Division’s Asset Management Unit, stressed, “[b]y failing to comply with Custody Rule provisions, Galois Capital exposed investors to risks that fund assets, including crypto assets, could be lost, misused, or misappropriated,” as was the case with FTX’s collapse.³ The SEC has brought nine other Custody Rule actions against advisers this fiscal year, usually stemming from advisers’ failure to conduct audits or distribute audited financial statements to investors within the required time period.

Advisers may face numerous compliance challenges in connection with managing client investments in digital assets:

• Uncertainty over Custody Rule application to digital assets. First among those is the uncertainty surrounding whether specific digital asset holdings are “securities,” as defined by the Securities Act of 1933. As the SEC has acknowledged on multiple prior occasions, a blockchain token, for example, is not itself a security. But the SEC is aggressively pursuing litigation alleging that tokens and other digital assets were offered and sold as investment contracts, and thus securities, under the U.S. Supreme Court’s test in SEC v. W.J. Howey, Co., 328 U.S. 293 (1946).
• Identifying qualified custodians. A second challenge is that, given the number and variety of digital assets, qualified custodians do not necessarily exist for all digital assets. As a result, there is no way an adviser could comply with the Custody Rule for numerous digital assets, even assuming those assets were, as the Galois order summarily characterizes it, “offered and sold as securities.”

While recognizing these questions and challenges, investment advisers, including those focused on digital assets, should consider assessing their safeguarding policies and procedures in light of this enforcement action and the SEC’s ongoing focus on Custody Rule compliance. 

¹Link here.
²For additional information about the rule proposal, see the following Sidley alert: SEC Proposes Sweeping Revisions to Advisers Act Custody Rule.
³Press release here.