Skip to Content

Adviser Loses Customer Crypto: Wallet Key Custody Not Airtight

On June 25, 2024, a final judgment was entered by a federal district court against investment adviser Lufkin Advisors LLC and its principal, Chauncey Lufkin, for losing access to a crypto wallet used to manage a client’s investment, among other violations. Allegedly, the principal lost or forgot the password, or “key,” needed to access the wallet, which had an estimated value of $10 million.

Among other things, the court directed the adviser to refrain from violating Rule 206(4)-2 under the Investment Advisers Act of 1940, also known as the “custody rule.” Further, the SEC subsequently revoked Lufkin LLC’s SEC registration and barred Mr. Lufkin from association with securities industry participants. Curiously, however, it is not clear that compliance with the existing custody rule would have prevented this loss.

For example, the current rule requires an adviser to maintain client “funds or securities” over which it has custody with a qualified custodian (e.g., certain banks or broker-dealers). Some client investments, however, (including some crypto assets) may be deemed neither “funds” nor “securities,” which can create uncertainty regarding custodial obligations under current requirements. In fact, in February 2023, the SEC proposed to replace the custody rule with a new rule to address perceived gaps in current protections. See “SEC Proposes to Remake Advisers Act Custody Rule for a Modern World.”

Would the proposed rule have protected the client any better? If complied with, almost certainly. Unlike the current rule, the proposed rule would require an adviser to safeguard client “assets,” not simply client “funds or securities,” by maintaining such assets with a qualified custodian (subject to certain exceptions), among other things. Use of the term “assets,” rather than “funds or securities,” would subject many non-traditional investments, including those crypto assets that could not already be considered funds or securities, to the proposed rule’s protections. Under the proposed rule, those protections would require that the custodian maintain “possession or control” of the advisory client’s assets.

Several approaches may exist, or be developed, that would satisfy this requirement in the context of crypto assets. For example, among other possible approaches, the custodian could maintain exclusive possession or control of crypto assets, or it could generate and maintain the private keys granting access to advisory client crypto assets such that the client’s adviser would be unable to change beneficial ownership of those assets without the custodian’s involvement. If, however, an adviser can transfer beneficial ownership of an advisory client’s crypto assets without the participation of the custodian, because, for example, the adviser alone possesses the only private key granting access to those assets, the requirements of the proposed rule would not be satisfied.

The proposed rule, however, has generated much controversy and resistance among crypto industry participants, not least because the proposed requirement of continuous control is at odds with crypto asset trading practices. The SEC reopened the comment period for the proposal last year, and in testimony before a Senate Appropriations Committee in June of this year, Chair Gary Gensler noted that he has asked SEC staff about potentially re-proposing the rule. In sum, the prospects for its adoption remain quite hazy at this time.

©2024 Carlton Fields, P.A. Carlton Fields practices law in California through Carlton Fields, LLP. Carlton Fields publications should not be construed as legal advice on any specific facts or circumstances. The contents are intended for general information and educational purposes only, and should not be relied on as if it were advice about a particular fact situation. The distribution of this publication is not intended to create, and receipt of it does not constitute, an attorney-client relationship with Carlton Fields. This publication may not be quoted or referred to in any other publication or proceeding without the prior written consent of the firm, to be given or withheld at our discretion. To request reprint permission for any of our publications, please use our Contact Us form via the link below. The views set forth herein are the personal views of the author and do not necessarily reflect those of the firm. This site may contain hypertext links to information created and maintained by other entities. Carlton Fields does not control or guarantee the accuracy or completeness of this outside information, nor is the inclusion of a link to be intended as an endorsement of those outside sites.

Disclaimer

The information on this website is presented as a service for our clients and Internet users and is not intended to be legal advice, nor should you consider it as such. Although we welcome your inquiries, please keep in mind that merely contacting us will not establish an attorney-client relationship between us. Consequently, you should not convey any confidential information to us until a formal attorney-client relationship has been established. Please remember that electronic correspondence on the internet is not secure and that you should not include sensitive or confidential information in messages. With that in mind, we look forward to hearing from you.