Throughout 2022 multiple crypto firms filed for bankruptcy. Then came FTX.
Experts say the Securities and Exchange Commission is homing in on venture capital funds investing in digital assets following market fallout that's turned a crypto fundraising boom to a bust.
The SEC’s Division of Examinations named “crypto-assets” and other emerging tech as a top priority for 2023 on Tuesday. The agency said it would examine broker dealers and registered investment advisers following “disruptions caused by recent financial distress.”
“The FTX issue amplified in the minds of the SEC the risks posed by investment advisers investing in crypto assets, so they are particularly motivated now to take a real look because there is actual harm that has befallen investors in these assets,” said Justin Browder, partner at Willkie Farr & Gallagher LLP.
The SEC is interested in two areas, Browder said — how investment advisers, including venture capital firms, are looking out for the best interest for their clients and how advisers are holding crypto for those clients.
Zachary Fallon, a former SEC attorney agreed that there have been “murmurs of the SEC probing investment advisers” regarding the custody rule. Fallon is now a partner at the law firm, Ketsal, which specializes in legal work for investment advisers.
Crypto companies raised $33.11 billion in 2022 from investors, and $631 million from January 2023 to now, while investors raised $99.297 billion in 2022 for crypto-related investment funds, data from The Block Pro Deals Dashboard show. Through that explosion in interest, followed by earlier high-profile firm collapses, the way crypto-related investment advisers follow fiduciary duty and perform custody of digital assets has been on the SEC's radar.
But FTX has amplified the risks investment advisers face, Browder said.
Investment advisers at a venture capital fund have a duty of loyalty, which includes mitigating or eliminating conflicts of interest, as well as a duty of care to make sure they are investing clients’ assets in areas that make sense for them.
When the market was doing well, there was less concern, so it was “no harm, no foul when people are making money,” Browder said.
“But as a result of the FTX fallout, you see what happens when the music stops, and it highlights all the risks associated with making investments in crypto and crypto related companies,” Browder said.
Registered investment advisers also are subject to a custody rule, which requires them to maintain those assets with a qualified custodian such as a bank or broker-dealer.
There is speculation that the SEC will look more closely to see if those registered investment advisers fulfill those obligations, Browder said.
More conservative advisers are holding clients’ assets with qualified custodians, such as banks, while others take a more aggressive approach and say the crypto they hold are not securities and so hold onto it themselves, Fallon said.
“Those folks may find themselves having some issues with respect to their compliance under the SEC requirements,” Fallon said. “So that type of scrutiny is certainly happening.”
Venture capital funds investing in tokens themselves, rather than a company, would fall under the same, Fallon said.
There is a certain degree of groupthink among venture capital firms, said John Reed Stark, a crypto critic and former chief of the SEC’s Office of Internet Enforcement.
“They are a big guy, they got in on it, we don’t need to do any due diligence, they did it for us,” Stark said.
Fallon also spoke about this kind of “piggybacking” among investment advisers. It is not uncommon, and not usually problematic, to have a lead investor that does the “grunt work” of negotiating the main terms and doing diligence, he said.
“Then everyone else that comes behind that lead usually gets the benefit of some comfort that the investor has kind of done the hard work,” Fallon said. That also is not crypto-specific.
Charlotte Savercool, vice president of government affairs at the National Venture Capital Association, said that rule change is the “most impactful proposal that the SEC is considering,” for all of venture capital, she said, not just crypto-focused funds.
Lisa Braganca, a former SEC enforcement branch chief, said she felt it was strange to hold venture capital funds liable for failing to do due diligence. Venture capital funds are set up to invest in early stage companies that are high risk, and those young companies don’t have some types of control, she argued.
Possible rule change in the pipeline
The SEC proposed new rules and changes under the Investment Advisers Act a year ago that would bring added transparency standards to private funds.
Some investors get preferential terms from those coming after them. All investors get standardized documents, but that first investor may get a side letter that says there will be a few other “sweeteners.” Those sweeteners may not be available to the other investors.
“So what the SEC is basically saying is, to the extent you have side letters, you need to tell people about those,” Fallon said.
“We’re concerned about the way the private funds proposal could change VC investment activity and willingness to take risks on new companies,” Savercool said.
Disclaimer: Beginning in 2021, Michael McCaffrey, the former CEO and majority owner of The Block, took a series of loans from founder and former FTX and Alameda CEO Sam Bankman-Fried. McCaffrey resigned from the company in December 2022 after failing to disclose those transactions.
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