Cryptocurrency Investments – What Financial Advisors and Planners Need Know to Avoid Legal Actions

Andrew Shedlock, Partner, Partner, Kutak Rock

Andrew Shedlock, Partner, Partner, Kutak Rock

Editor’s note: This article is an adaptation of the live webinar delivered by Andrew Shedlock, in 2022. His comments have been edited for clarity and length.

You can read the summary article here as part of the October 2022 Retirement InSight and Trends Newsletter, worth 1.0 CE when read in its entirety (after passing the online quiz.)

You may also choose to take the full length course Cryptocurrency Investments – What Financial Advisors and Planners Need Know to Avoid Legal Actions
for 1.0 hour continuing education (CE) credit.

By Andrew Shedlock, Partner, Kutak Rock

My goal is to help planners and fiduciaries understand the basis of cryptocurrency investments, what a crypto token is, what Bitcoin is, and how they work. I want to inspire you to learn more about what I can trigger in your mind about cryptocurrency.

First, crypto is an alternative investment. Read everything you can about it, and you will understand that my advocacy is a little more realistic and more skeptical than people in the crypto space. I am a crypto realist, not a crypto bro or a crypto pumper. I don’t necessarily think it will change the world and take over the financial system. That being said, I think there is real potential for these types of products, and that is what they are – products – to impact the financial space, to change our jobs, to fundamentally upend what we have done for so many years.

Second, I want to make this practical for planners and advisors to understand the main areas of risk and liabilities that planners and others face when they work with clients using cryptocurrency investments and how to discuss the intricacies and details of various types of cryptocurrencies with clients. I also want you to know the difference between a cryptocurrency and a crypto token. I want you to know the difference between Bitcoin and Ethereum. I want you to know the difference between a hot wallet and a cold wallet. So when your clients come in to discuss crypto with you – not if, but when – I want you at least to have a working knowledge, so you do not stare at them blankly and say, “I have no idea what you are talking about.”

How can we as planners avoid and lessen the risks and potential liability when dealing with regulators when it comes to cryptocurrency investments? Here we’ll talk about not only papering up the file but figuring out, “What do I need to have in my files? What documents do I need for crypto investments that I do not need when it comes to BTS, stocks, bonds, and everything else we work with our clients on to help them achieve their investment goals?”

This article will particularly emphasize the retirement space because it is crucial to understand the potential pitfalls of dealing with these products and issues in the retirement space, which is different than if we are dealing with it in a brokerage account or “fun” money.

What is cryptocurrency?

Cryptocurrencies start with a blockchain. The blockchain can be described in several ways, such as an immutable source of information that can be easily verified and never falsified.

We are all familiar with the process of buying a house. When we buy a house, we acquire a deed, we have to pay someone to do a title search for that deed, we have to figure out if there are any liens on the house, we have to figure out if the title is clean, if it is a good title, or if someone else has a claim to this house we are about to buy that is dangerous or could impact what we want to buy. Think of the blockchain as blocks of information that could form the parts of a title or a title chain analysis.

For example, say a house was sold in 1970; the sale is recorded in a book in a recorder’s office in some county and tucked away neatly in their library. This would require someone to physically check those books and figure out the exact title chain before we can certify there is a clean title. Technology has improved that process, but in this example, the blockchain is entitled to make that process quick, simple, and completely verifiable. So, when I record the title of a house I buy, it goes on the blockchain and to everyone else on that blockchain. They are responsible for verifying that the information I put on the blockchain is correct.

It is instant verification, not from a bank, not from one person, not from a Fin Op department, but from 10,000 people, more or less, to verify exactly that information is correct. This is the basis of a blockchain. Now, is it far more complicated than that? Of course, the whole point of cryptocurrency and the blockchain is that it is immutable, can be traced back instantly, and is verified.

Now let’s talk about cryptocurrency. This leads us to Bitcoin. Bitcoin is a cryptocurrency, Bitcoin has its own blockchain, and nothing else goes on that blockchain except Bitcoin. The price of Bitcoin is about $24,000 per Bitcoin now. It got as high as $69,000 a year ago, then it suffered a crash of about 50% over the next year. Bitcoin is placed on the Bitcoin blockchain, and every Bitcoin has a unique identifier that only one person can own that specific Bitcoin. When someone buys that Bitcoin, it goes on the blockchain, and other people on it validate that transaction occurred for that price.

How is a crypto token different than a cryptocurrency? The leading blockchain for crypto tokens is Ethereum. Many different crypto tokens can be placed on one blockchain, such as Ethereum, whereas a cryptocurrency is only attributed to one blockchain. Are they different in that respect? Yes. Are they different in terms of the investment options we will discuss today? Not necessarily.

But it is things like this, as we talk about going forward, that you need to educate yourself about because your client may come in and say, “I want to buy crypto.” Your first question is, “What do you mean by that?” They may say, “I want to buy Bitcoin.” “Okay, let us talk about the risks and benefits of Bitcoin.” If they come in and say, “I want to buy a crypto token,” that is an entirely different conversation.

You and I can create our own crypto token in an instant. For example, anyone can create a company. Say I create Joe’s Hot Dog Stand and sell shares in Joe’s Hot Dog Stand, provided I comply with pertinent security regulations that require me to register those securities or be exempt from registration when selling them. If you have the computing prowess and the technological background, you too can create your own crypto token, which is a very different discussion than Bitcoin. However, not all crypto tokens are legitimate or worthy of investment.

Crypto tokens are much riskier because they can spring up overnight and be the subject of pump-and-dump schemes. Your clients could be excited because someone mysteriously airdropped 100 crypto tokens into their wallet. Why would someone airdrop crypto tokens into wallets? To raise the profile of that crypto token and to create interest. What happens when someone airdrops a crypto token into a client’s wallet? People start buying more and more of it because they are excited about its release. It is the next Dogecoin, Bitcoin, or Ether.

The promoter of those crypto tokens can pump the value up. Since they hold most of the tokens and sell at a higher price, guess who is left holding the bag? All those people who bought into the hype bought into the pump-and-dump scheme. This doesn’t happen often, but what happens with crypto tokens is much different than what happens with Bitcoin.

There is far more risk for crypto tokens than for Bitcoin or Ethereum.

The logistics of helping clients invest in crypto

No crypto investment is appropriate or suitable for any client simply because it can potentially generate high returns. I am a crypto realist, and there are many problems in the space. There is a complete lack of regulation; the SEC’s enforcement actions can damage this industry. An investor wanting to get into this space, especially if the space is not Bitcoin or Ethereum, could be damaged by crypto token pump-and-dump schemes or other issues. You must know what you are doing before you get into this space. As an advisor, planner, or fiduciary, you must know how these investments and products work.

A year ago on LinkedIn, a planner posted, “The target goal for any investor should be to have three percent of their investment holdings in crypto.” Wait a minute. First, any fiduciary knows that no planner, no fiduciary, or broker should tell a client, much less publicly, that everyone should have at least three percent of their holdings in any investment, whether crypto or otherwise. The risk profile for an 80-year-old retiree is much different from a 40-year-old working, high-income earner. We are in for some enforcement actions and things that could be damaging to clients and lead to lots of lawsuits against advisors.

What have I seen about how planner and investment advisor clients invest in crypto in the past few years? You can buy Bitcoin, Ether, and crypto tokens through an exchange. And what does that mean? Let’s talk about two that are like E*TRADE: Coinbase and Robinhood. A client can go into Coinbase, open an account, and fund that account. Then they say, “I want to buy $8,000 worth of Bitcoin and $2,000 worth of Ethereum.” How does that happen? Coinbase would buy $8,000 worth of Bitcoin for you and put that into your account; the same with Ethereum. Robinhood does something similar where you can buy cryptocurrency investments through Robinhood, which targets a younger audience.

There are suitability aspects of investing in cryptocurrencies. Risk disclosures are important here. Advisors or planners should refrain from recommending that their clients invest in any crypto product. However, if your clients mention crypto investments, want to invest in crypto, if your firm allows it, and if you are comfortable with it, you need separate risk disclosures for clients investing in crypto. So, caveats galore.

What are the risks of crypto?

Cryptocurrencies and crypto tokens are alternative investment products with significant risks. Why?

First, there is a complete lack of regulation in this space. To those of you who have been following the news, and it is hard to miss at this point, you know that there is a deep battle going on between the Securities and Exchange Commission (SEC) and the CFTC (Commodity and Futures Trading Commission), about who regulate things like Bitcoin, cryptocurrency, crypto tokens. The only thing the SEC and CFTC agree on is that Bitcoin is not a security but a commodity. Even the SEC Chairman, Gary Gensler, agrees that Bitcoin is a commodity. Why is that important?

The SEC has less regulatory authority, if any, over commodities as compared to securities. The CFTC has regulatory authority over commodities, and Bitcoin is a commodity; it will be regulated as such and has been regulated as such. Now, that is not to be said that the SEC has not brought significant enforcement actions for Bitcoin-related scams. Again, one of the significant risks of crypto is regulation because there is no regulation. There are no sets of rules. There are no FINRA rules, and there are no SEC rules.

Why is lack of regulation a risk? Because we do not know what will be allowed and not allowed in the future or now. Planners and investment advisors are playing the game at their own risk, so to speak. I do not know if, in five months, the SEC will come out with rules that say, “Planners and advisors cannot recommend these types of products, or if they do, they have to fill out this form or consider these factors.” So, you are playing on shaky ground.

Regulations are constantly changing. We have seen that with cybersecurity rules that the SEC is putting out, with different ESG rules. The point here is that now there is only regulation through enforcement, which heightens the risk.

So the next great battle in crypto is who will regulate this? It matters because, as an advisor, I want to know the rules. The SEC and FINRA will be much harder on Bitcoin, on crypto and crypto tokens, compared to the CFTC, which is why so many crypto supporters and participants want the CFTC to regulate it. Gary Gensler does not have a good reputation as a Bitcoin or crypto supporter, and he is on record as saying that most crypto investments are worthless.

As an advisor, if you talk to clients about these products, help them invest, or give them any advice, you need to know that the current composition of the SEC and the current SEC chair views essentially all crypto products save for Bitcoin as worthless. This should influence your thinking, what you talk to clients about, and how careful you are.

Crypto and retirement accounts

Fidelity now allows its clients and employers to invest up to 20% of their accounts into Bitcoin. This was shocking to me. There is a burning desire for their clients to invest in these products. So, Fidelity said, “It is a great idea for us to allow them to invest in retirement accounts.”

The Department of Labor had guidance before Fidelity’s announcement, saying, “Not so fast.” Under ERISA, the DOL noted that fiduciaries who run these retirement plans and 401Ks must act solely in the financial interest of plan participants and the exacting standard of professional care. So, a fiduciary’s consideration of whether to include an option for participants to invest in cryptocurrencies is subject to these exacting responsibilities. This screams enforcement actions and lawsuits from the Department of Labor against these providers when the inevitable crash happens.

So, why would Fidelity do this? Because of the demand from clients. Demand is only sometimes the right answer, especially in ERISA-regulated plans. Who is driving this demand in Fidelity and others? Millennials, of course. Twenty-eight percent of Millennials said they expect to use crypto to support themselves in retirement. Fidelity has said, “We disagree with the DOL. We have different views than the Department of Labor regarding the guidance they issued. We believe they should withdraw that guidance.” This might be litigated. I am sure they have had their attorneys back this down quite a bit to figure out an appropriate risk-reward, but that is an honest quote to me. “We just disagree and think it should be withdrawn.” Let us see who wins that battle.

Should I wade into crypto versus dive?

There are people in this space who are fiduciary advisors that absolutely think that you should jump all in and get your clients in this and that you are violating your fiduciary duty if you do not do it.

Advisors should not dive into Bitcoin. These big, wild swings are very dangerous because on any swing up, you are bound to get a swing down, and you are bound to hurt some investors. Maybe you should not dive in, but what if you wade into the crypto pool? Take three simple steps

. The first and foremost thing you have to do is educate yourself. This is very easy to do. Take a couple of hours, Google some articles, and read resources. There are plenty out there for financial advisors who are getting into the crypto space or at least want to talk to their clients about it.

Why is this important? It is not because I think it is a good investment or appropriate for retirement. To be clear, it is generally not appropriate for retirement. However, your clients may ask you about it, and it is your duty to educate your clients and yourself about what that means. Here is a great Kitces article that highlights what advisors should do. This article talks about hot wallets and cold wallets, and it talks about hot storage and cold storage. These are the types of articles you, as fiduciary advisors, should be reading. Almost every day, a new article about Bitcoin, the blockchain, and advisors comes out.

I can tell you that more and more of your clients, if not many of your clients, will come to you to talk to you about crypto investments, or they will tell you, “Hey, I have invested in this crypto off to the side. I know you cannot hold it for me in your account and cannot custody it with TD Ameritrade, but I want you to know because this influences my financial plan. You need to know what that means when something is “held away”; you need to know if they have it in hot or cold storage. You need to know if they have cryptocurrency or a crypto token because then you could tell them more about the risks of each product.

Secondly, consider your fiduciary duty. A fiduciary is bound by law to consider their fiduciary duty. Here is a link to another article you should read when you get a chance. Some people in the crypto space for advisors, those who educate advisors on crypto, think that certain advisors are violating their fiduciary duty to clients by not investing their clients in crypto and not educating them about crypto.

This is the minority view. Advisors who think that crypto is an appropriate, suitable investment for many investors think that it could contain the key to your investing life or make huge, outsized returns that could secure your retirement. A couple of well-known names in this space are really pushing this and pushing advisors to become more educated. I am all for advisors getting more educated, but I do draw the line about whether or not you are violating your fiduciary duty by failing to get clients invested in this space.

Yes, educate your clients and be capable of discussion, but you are not violating your fiduciary duty if you are not helping clients get in here. These are suitable investments sometimes, maybe in limited circumstances for specific clients, but certainly only for some clients. Most firms will not allow advisors at this stage to certainly custody or even attempt to custody any assets or recommend any custody of crypto assets.

You need to know what your firm says about compliance with crypto. If your firm does not have training and manual sections on cryptocurrency investments, they should. Whether that means a blanket prohibition, “We do not discuss it. We will not do it,” whatever it is, the time is past. It is time to get educated about these products. It is time for your firm to have a position, whether it is “Proceed with caution,” “Proceed with extreme caution,” or “Stop fully.” If your firm does not have it, they need to figure it out and take a position on it.

What if the SEC and FINRA come calling?

You better believe that if you advise a client to invest in something or buy something that is a security without making appropriate disclosures, the SEC could come down on you.

Assume you have a client come in, and you say, “You have been with us 20 years, John Smith, and you have done great. Here are your holdings. You have two million dollars and are well on track for retirement.” John Smith says, “Well, I know we have not met in six months, but Bitcoin crashed, and I saw an opportunity, so I took $100,000 from my 401K and cashed it out. Now I have a Coinbase account with four Bitcoin worth $100,000.” I need you to stop right there and figure out a few things.

First, as an advisor, almost all cryptocurrency investments are being held away, whether it is Bitcoin or these tokens. That means that your firm cannot custody them, your custodian cannot custody them, and they are being held away at a Coinbase account, a Gemini account, or a account. Your fiduciary duty is to understand precisely how many of your clients are holding away assets in cryptocurrency and investments and why this is.

First, you need to know if your clients are holding money in separate accounts anyway because you need to be able to give them a precise financial plan and help them plan out their future. Second, the wild market swings and price of Bitcoin are very important for advisors to know about, and if John Smith says, “I have four Bitcoin today,” in two months, he could still have four Bitcoin but have $20,000 less in his financial plan. That may not be a huge deal for John Smith. That may be fun money for John Smith, but you need to know that their fun money could go to zero and how that will affect their financial plan. You could start tracking. Check the price of Bitcoin once a day. I hope John Smith himself is tracking how much the price of Bitcoin is in his account.

You need to have written disclosures detailing how much these clients are holding away. I strongly recommend, and we have done this for some of our broker-dealer clients here at the law firm, you need to have separate risk disclosures for your clients if they are investing in Bitcoin or other cryptocurrency investments.

You need to have some sort of form. It does not have to be a complex form. If clients come to talk to you about crypto or if they want to invest in crypto, or if they want your advice on crypto, assuming you can even give advice, you need to have some sort of basic form that walks them through the risk disclosures of crypto. And why is that?

It is because there are these pump-and-dump schemes out there. It is because the price of Bitcoin has fluctuated violently and wildly for the past several years. It can impact their financial plan in ways mutual funds, ETFs, or single stocks like Microsoft cannot. Microsoft may drop 20% when the market drops 20%, but it is more than likely to go up again when the market goes up again. The same is different for Bitcoin. While there is little correlation between the price of Bitcoin and the general market, when the market goes up, Bitcoin will go up, but not always. When the market goes down, Bitcoin may go down a lot more.

You must educate your clients through written risk disclosures, whether simply checking the box, “Initial here understanding that there is extreme volatility, that this is not a normal, standard investment,” or that the client is doing this of their own volition. You cannot put things in writing enough.

Document exactly how much cryptocurrency investments are being held away by the client. I recommend that you always paper the file with risk disclosures. You know the client is at risk investing in crypto; maybe you did not advise them to do that, or you advised them against that. Paper up the file. At least educate them on the risks. You are protecting yourself. All it takes is for one client to lose $200,000 to complain to the SEC, FINRA, or whoever else that “My advisor did not tell me A, B, and C,” and then that is a whole other burden you do not want to have.

Key Takeaways

  1. Educate yourself. Read the Kitces article I mentioned earlier, and read other articles written by some of the prominent names in crypto for financial advisors. You can never stop learning.
  2. Follow the SEC’s twists and turns. Look at what enforcement actions they are bringing in the crypto space. This is a new age of regulatory holdings and court cases changing the fundamental nature of securities regulation. These times are exciting as an attorney in the securities regulation and litigation field. It is rather interesting to know, “Hey, we can have a change in regulator, a change in approach.” I would not be surprised that within the next few years, we get a new Supreme Court case, a new holding, about “What is a security? How do we evaluate a security? What is the nature of administrative regulation?” and things like that.
  3. Protect yourself by documenting everything. Assets holding away and risk disclosures are two things you should do the second you hear “crypto” from a client. Please work with your firm to figure out what they are comfortable with, what they are willing to do, and what they are not willing to do.

This is all under the guise that there is a tidal wave here of crypto, and it is not going away. Whether it changes the world or not, who knows? But we are at a turning point. It is not going away, and it is not going to be a one-off. It is not necessarily an appropriate investment, but at the same time, when we consider retirement aspects and retirement accounts as the younger generation comes up, as those millennials turn into 40, 50-year-olds or inherit their parents’ money, they might say, “Hey, I have $500,000 in fun money. What should I do with it?”

About Andrew Shedlock, Partner, Kutak Rock

Andrew Shedlock is a partner with the Kutak Rock law practice in Minneapolis. He is a litigator and attorney for financial advisors, financial planners, RIAs, and broker-dealers.  Andrew advises on Non-Fungible Tokens (“NFTs”), cryptocurrency and Bitcoin, including securities and contract matters in those areas. Using his securities and regulatory background, he and his firm assist participants in the crypto, defi, blockchain and defi space to comply with laws and regulations, be proactive and drive development and investments in this developing space.

Andrew also provides legal and regulatory advice to businesses and individuals in the securities industry, including broker / dealer compliance, investment due diligence, regulatory compliance, SEC and FINRA investigations, Rule 8210 actions and CFP issues. His extensive background in securities litigation, investment fraud and general commercial litigation enables him to efficiently help clients when they are facing changes, challenges, investigations, lawsuits and other unpredictable events, including guiding and counseling advisors and brokers going independent through all stages of the process to avoid and lessen the risk of litigation where possible.

Retirement Speakers Bureau

Retirement Speakers Bureau

Are you looking for a retirement speaker for your next conference, consumer event or internal professional development program? Visit the Retirement Speakers Bureau to find leading retirement industry speakers, authors, trainers and professional development experts who can address your audience’s needs and budget.

©2022, Andrew Shedlock, Partner, Kutak Rock. All rights reserved. Used with permission.

Posted in: PROVIDE Retirement Income, Retirement Income Planning and Spending

Leave a Comment (0) ↓