Sep. 29, 2022

Custody Rule Dilemmas in DeFi Investing

For private fund managers using decentralized finance (DeFi) protocols in connection with their investment activities, technical compliance with the qualified custodian requirement under Rule 206(4)‑2 (Custody Rule) may not be possible. To the initiated, this comes as no surprise. Although the SEC amended the Custody Rule in 2003 to reflect then-modern custodial practices, those practices have since changed. An observation made by the SEC in its 2002 proposed Custody Rule amendments remains equally applicable today: “Advisers’ business practices also have evolved, increasing the likelihood that advisers may obtain custody of client assets in circumstances that [the SEC] may not have anticipated. . . .” In a guest article, Oscar Saunders, counsel at Linklaters, provides an overview of the qualified custodian requirement under the Custody Rule (Qualified Custodian Requirement), describes DeFi-related investment activities and illustrates how those activities may impact compliance with the Qualified Custodian Requirement. See “Navigating Custody and Other Regulatory Issues Associated With Digital Assets” (Aug. 4, 2022).

AI Compliance Playbook: Traditional Risk Controls for Cutting‑Edge Algorithms

The corporate use of artificial intelligence and machine learning (AI/ML) skyrocketed during the coronavirus pandemic, with organizations across the economy investing in algorithmic tools to boost capabilities and tackle major problems. Public questions about misuse have accelerated too, with one in the center spotlight: Is your algorithm fair? Companies have responded by adopting AI/ML ethics policies. Yet, leaders from these firms contend that they now need more than an ethics policy and are advocating governmental regulation. This first article in a three‑part series seeks to fill in the current regulatory gap by describing essential steps for an AI/ML compliance program, including adapting 1970s anti‑discrimination practices to meet the future. It also reports on data scientists’ recent compilations of AI/ML failures. The second article will detail seven AI/ML risks that entities now face, and the third article will discuss both cutting-edge AI auditing and the venerable “three lines of defense” approach. See our three-part series on new AI rules: “NYC First to Mandate Audit” (Jul. 28, 2022); “States Require Notice and Records, Feds Urge Monitoring and Vetting” (Aug. 4, 2022); and “Five Compliance Takeaways” (Aug. 18, 2022).

SEC Reiterates Standards of Conduct for Advisers and Broker‑Dealers As to Conflicts

The SEC’s focus on conflicts of interest cannot be understated. A recent staff bulletin (Bulletin) discusses conflicts by asking and answering 13 questions about the respective standards of care and duties for investment advisers and broker-dealers (collectively, firms). The Bulletin focuses on identification of conflicts; conflicts associated with both compensation received by firms themselves and compensation of their representatives; mitigation and elimination of conflicts; and ways firms should disclose conflicts. In addition to noting that dealing with conflicts should not be a mere “check-the-box” exercise, the Bulletin stresses the need for appropriate policies and procedures; that firms must address not only firm-level conflicts but also conflicts that may affect how their financial professionals render advice; the importance of clear disclosure; that some conflicts are so significant that disclosure is not enough and, in those cases, mitigation or elimination is required; the need to document conflicts-related practices; and that managing conflicts is just one element of acting in the best interests of clients. This article synthesizes the staff’s guidance. See “Recent Experiences With SEC Examinations and Enforcement: Disclosures, Conflicts and Trading Issues (Part Two of Two)” (Dec. 16, 2021); and “SEC Exam and Enforcement Priorities: Cybersecurity, Business Continuity and Conflicts of Interest (Part One of Two)” (Jul. 22, 2021).

U.K. FCA: Retail Funds May Use Side Pockets to Hold Assets Affected By Russia‑Related Sanctions

Retail investment funds are required to maintain sufficient liquidity to enable them to meet frequent redemption requests. When the U.K. and other nations imposed economic sanctions on Russian actors in response to the invasion of Ukraine, many Russia-related investments plunged in value and could no longer be liquidated. To address that concern, in July 2022, the U.K. Financial Conduct Authority adopted rules that permit retail funds to put assets affected by those sanctions into side pockets. A recent Simmons & Simmons program discussed the applicability of the side pocket rules, their primary requirements and the key concerns for fund managers that may wish to create a side pocket. The program featured Andrew Desmond and John Dooley, both managing associates at Simmons & Simmons; and Rachel Ellison, retail fund compliance specialist at The Investment Association, a U.K. funds industry trade association. This article distills their insights, with additional commentary from Dooley. See “Scope of Global Sanctions From the Ukraine/Russia War and How Designated Person Standards Affect Fund Managers (Part One of Two)” (Jul. 21, 2022).

Jail, $8.5‑Million Forfeiture and Industry Bar for Securities Analyst in Front‑Running Scheme

In 2021, the SEC and DOJ charged a securities analyst with multiple counts of securities fraud in connection with a years-long front-running scheme in which he allegedly made approximately $8.5 million in illicit profits by trading ahead of his employer, a large investment adviser, in an undisclosed account in his wife’s name. Earlier this year, the analyst pleaded guilty to one count of securities fraud, forfeited his trading profits and was sentenced to jail for his crime. The parallel SEC enforcement proceeding ended with an industry bar for the analyst, injunctive relief and a disgorgement order. This article details the terms of the civil and criminal resolutions, with thoughts on the implications of the actions from Akin Gump partner Brian Daly. For more on personal trading, see our three-part series on code of ethics fundamentals: “Why Fund Managers Need Them” (May 20, 2021); “What They Must – and May – Include” (Jun. 3, 2021); and “How to Monitor and Enforce Compliance With Them” (Jun. 10, 2021).