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FINRA Requires Broker-Dealers to Obtain Special Approval to Offer Digital Securities

Updated: Oct 5, 2020

Not to be left out of the growing quagmire of the U.S. regulatory framework around digital assets, the Financial Industry Regulatory Authority (FINRA) recently issued Notice 20-23 requiring firms to notify FINRA if they engage in any activities related to digital assets, or even if they are just thinking of engaging in these activities. As a corporate and securities attorney for emerging technology companies, I am subscribed to a regular buffet of email listservs for U.S. regulatory agencies, and so I was aware of this notice, as well as two previous notices issued on the same subject. However, upon review, I relegated them to the pile of interesting, but not critically important, quasi-governmental notices - until recently.

These past few months I have been busily buried with preparations for a substantial digital securities offering for the Libra Project. Part of this preparation process involves interviewing FINRA-registered securities broker-dealers for a good fit to help place the private offering with interested accredited investors. This particular offering is challenging for two reasons. First, the primary regulatory agencies of the U.S. federal government treat digital assets rather unfavorably. For example, the Securities and Exchange Commission (SEC) assigns securities treatments to digital assets nearly by default. If you can convince the SEC the digital asset is not a security, then the Commodities Future Trading Comission (CFTC) is more than happy to step in and regulate the asset as a commodity. Further, if you're operating a virtual currency, the Financial Crimes Enforcement Network (FinCEN) requires you to register as a money service business; but the Internal Revenue Service will tax virtual currency transactions as property. Second, I have had more than one securities broker advise me that they are wary of brokering digital securities because of recent changes in FINRA treatment of digital assets, citing Notice 20-23 as a reason.

For the sake of context, FINRA is the quasi-governmental organization authorized by Congress to regulate all securities brokers-dealers in America. In close relationship with the SEC and CFTC, FINRA enacts rules and publishes guidance for securities firms and brokers-dealers, and it maintains the central licensing and registration system for the U.S. securities industry and its regulators. FINRA maintains the Central Registration Despository that contains the registration records of all broker-dealer firms and their associated individuals, including their qualification, employment and disclosure histories. You can check out anyone claiming to be a FINRA registered securities broker-dealer on the FINRA Broker Check website.

A Joint Staff Statement on Broker-Dealer Custody of Digital Asset Securities released by FINRA and the SEC on July 8, 2019, addressed several concerns about the application of the Customer Protection Rule to registered broker-dealers dealing in transactions involving digital securities. All broker-dealers must comply with broker-dealer financial responsibility rules, including custodial requirements under Rule 15c3-3 of the Exchange Act known as the Customer Protection Rule (CPR). As the statement explains, the CPR "... requires broker-dealers to safeguard customer assets and to keep customer assets separate from the firm's asets, thus increasing the likelihood that customers' securities and cash can be returned to them in the event of the broker-dealer's failure." While the implementation of this rule has had a fabulous 50-year track record for recovering investor funds when broker-dealers have failed, this record has been challenged by recent reports of cybertheft.

Under FINRA rules, a firm is prohibited from materially changing its business operations (e.g., engaging in material digital asset securities activities for the first time) without FINRA's prior approval of a Continuing Membership Application ("CMA")

Why? As the statement explains, there are several important distinctions in the mechanics and risks involved with the custody of traditional securities versus digital asset securities, and the joint agencies are very concerned that broker-dealers holding custody of digital asset securities could be victimized by fraud or theft, could lose a "private key" required to transfer the securities to their client, or they could transfer the securities to the wrong address, without recourse to reverse errors. Where broker-dealers, including ATSs, wish to use an issuer or transfer agent as a proposed "control location" for meeting requirements under the CPR, FINRA will consider whether the issuer or the transfer agent can be considered a satisfactory control location.

Returning to this problematic Notice 20-23, FINRA requires each firm to promptly notify its Risk Monitoring Analyst if it, or any of the firm's associated individuals, engages in, or intends to engage in, any of the following activities (which list is not exhaustive). If any firm does so, they may be required to file a CMA with FINRA to acquire separate FINRA approval, a process which can take several months to complete. For a good overview on what firms can expect FINRA to require, see this Article published by KoreConX on interview of Ken Norensberg, Managing Director of Luxor Financial, the first to acquire such approval.

  • Purchases, sales or executions of transactions in digital assets;

  • Purchases, sales or executions of transactions in a pooled fund investing in digital assets;

  • Creation of, management of, or provision of advisory services for, a pooled fund related to digital assets;

  • Purchases, sales or executions of transactions in derivatives (e.g., futures, options) tied to digital assets;

  • Participation in an initial or secondary offering of digital assets (e.g., ICO, pre-ICO);

  • Creation or management of a platform for the secondary trading of digital assets;

  • Custody or similar arrangement of digital assets;

  • Acceptance of cryptocurrencies (e.g. bitcoin) from customers;

  • Mining of cryptocurrencies;

  • Recommend, solicit or accept orders in cryptocurrencies and other virtual coins and tokens;

  • Display indications of interest or quotations in cryptocurrencies and other virtual coins and tokens;

  • Provide for facilitate clearance and settlement services for cryptocurrencies and other virtual coins and tokens; or

  • Recording cryptocurrencies and other virtual coins and tokens using distributed ledger technology or any other use of blockchain technology.

In conclusion, U.S. companies offering digital securities in a private placement just got a lot more complicated. While the senior management of a company can sell the company's securities to raise money without the assistance of a broker-dealer, most don't have the connections to do so. This is where the services of a FINRA registered broker-dealer can be quite helpful. However, if the company is selling digital securities registered on a blockchain, the only broker-dealers they can work with to help place the offering are those that have acquired this special permission. According to my research and several conversations I have held in the last week about this subject, approximately five brokerage firms in the U.S. have acquired such FINRA approval, potentially raising the cost for startups seeking services from these firms.

Alternative options for businesses to consider include:

  1. Conduct your private offering using traditional securities;

  2. Conduct your private offering without the assistance of a FINRA registered broker-dealer; or

  3. Change your private offering to a public offering using Regulation A+ Tier 2 - the "mini-IPO".

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