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8 Tips for Advisors to Avoid Digital Asset Legal, Compliance Headaches

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What You Need to Know

  • If an advisor wasn't compliant and erred when recommending digital assets to clients that resulted in harm, you can expect it to be reported to SEC Enforcement.
  • Advisors must make sure they’re following their firm’s policies and procedures, as well as legal compliance requirements.
  • Custody is especially tricky when dealing with digital assets because a lot of ambiguity remains about the rules.

When it comes to digital assets, advisors must make sure they’re following their firm’s policies and procedures, as well as legal compliance requirements, to avoid legal woes. And that’s just for starters, according to Max Schatzow, an investment management and regulatory attorney who is a partner at the law firm Stark & Stark.

“I’m a digital asset realist. … Some might call me a skeptic,” he said Wednesday in the session “The Compliance Landscape: What Can I Tell My Clients About Bitcoin?” at the virtual Bitcoin for Advisors event.

If the SEC finds out you weren’t compliant and erred when recommending digital assets to clients that resulted in harm and investment losses, “you can almost guarantee you’re going to get referred to” SEC Enforcement, he warned.

Schatzow provided several tips for advisors to consider before they jump on the crypto bandwagon.

Here are the eight standout tips he provided:

1. Advisors must follow their firms’ policies and procedures.

If you own your own RIA firm, “there is really very little stopping you from talking about Bitcoin and recommending Bitcoin to your clients,” Schatzow said. But if you work for somebody else’s firm, you are “bound by” what that company’s rules are on crypto, he noted.

Those policies and procedures include recommendations regarding held away assets and on-platform assets; whether you have discretion over the client’s assets; custody, including the client’s wallet, key or password; and personal trading and reporting rules, Schatzow said.

2. Advisors must consider all risks to their clients.

“If you’re going to recommend an asset to a client, you’ve got to make sure you’ve done due diligence on the asset,” he warned. “You’ve got to understand the asset you’re recommending to clients” and any risks involved, including risks that are not exclusive to digital assets, he said, noting there is “a lot of volatility” with Bitcoin.

3. Pay close attention to ensure you are living up to your fiduciary duties as an advisor.

“You’ve got to know your client,” he said. “You’ve got to know their objective and, as a legal matter, you have to provide advice that is in their best interest” as a fiduciary.

Advisors should also have a strong note-taking system so that if a client insists that you make a risky investment for them that ends up costing them a lot of money, you can prove the client understood the risk and wanted it anyway, he explained.

The price that you execute a digital asset trade at is also important, along with any other costs, he said.

Advisors also have a fiduciary duty to monitor digital assets and industry trends about them, he added.

4. There are record-keeping obligations advisors must also follow.

Advisors must follow Rule 204-2, which requires every SEC-registered investment advisor to retain copies of all ads and other communications that the advisor has circulated, directly or indirectly, to 10 or more clients and other people not connected with the advisor. Advisors must also create and retain all documents necessary to substantiate any performance information contained in ads.

5. Make sure to follow all custody rules.

“Custody is the rule that probably has the least clarity,” Schatzow said. “There is just so much ambiguity when it comes to custody and digital assets.”

Thus, advisors must understand how the digital assets are kept safe for clients and every other issue related to custody of those assets, he explained.

6. Always make sure to follow disclosure rules.

Disclosure is a significantly critical issue, he said, noting that advisors must make sure they are disclosing the appropriate information about digital assets. If in doubt, it is important to discuss the issue with the firm’s legal department, supervisors or both.

7. Make the correct valuation and advisory fee calculations.

“How you value your client’s Bitcoin” is a key issue, he said. “You need to make sure that you’ve been thoughtful in how you’re valuing, billing and deducting your advisory fees from client portfolios when it comes to Bitcoin and other digital assets.”

Advisors must also be careful about how they are calculating assets under management based on the correct regulating agency, he added.

8. Avoid errors and omissions when it comes to insurance coverage.

The last major issue he covered was making sure to avoid mistakes when it comes to insurance coverage. “Most errors and omissions policies do not cover digital assets,” he warned.

Therefore, if you receive a client complaint, such as one that assets have vanished, “you might not have coverage unless your errors and omissions insurance covers that activity and that asset class,” he explained. Advisors may want to add more insurance coverage, he added.

(Pictured: Max Schatzow of Stark & Stark; Photo: Stark Stark)