Tag Archives: digital asset regulation

Digital Asset Regulatory Items – Third Quarter 2018

The third quarter of 2018 saw increased interest from regulators in the digital asset space, as well as enforcement actions. For your convenience, we have provided an overview of key items from the quarter below.

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SEC MATTERS

Enforcement

SEC Charges Digital Asset Hedge Fund Manager

On September 11, the Securities and Exchange Commission (“SEC”) announced the settlement of charges against a digital asset hedge fund and its manager. The charges included misleading investors, offering and selling unregistered securities, and failing to register the hedge fund as an investment company. The manager marketed the fund as the “first regulated crypto asset fund in the United States” and claimed the fund had filed registration statements with the SEC. Based on investments in “digital assets that were investment securities”, the fund was required to register as an investment company with the SEC. However, the fund was not registered and did not meet any exemptions or exclusions from the investment company registration requirements. The settlement included cease-and-desist orders, censure, investor rescission offers, and a $200,000 penalty. This is the first action the SEC has taken against a digital asset fund based on violations of the investment company registration requirements.

SEC Charges ICO Platform for Operating as Unregistered Broker-Dealer

On September 11, the SEC settled charges against an initial coin offering (“ICO”) platform. The business and its principals were charged with failing to register as broker-dealers and selling unregistered securities. This is the SEC’s first charge against an unregistered broker-dealer in the digital asset space following the SEC’s 2017 DAO Report, which cautioned anyone offering or selling digital assets to comply with federal securities laws such as broker-dealer registration requirements. The business agreed to pay $471,000 plus prejudgment interest, and the principals each agreed to a three-year bar from certain investment-related activities and $45,000 in penalties.

SEC Fines and Halts Fraudulent ICO

On August 14, the SEC settled charges related to an ICO. The token issuer was charged with fraud and the sale of unregistered securities after it claimed the proceeds from its ICO would be used to fund oil drilling in California. However, the issuer falsely represented that it had the necessary drilling lease and misled investors about the potential for profit and the prior bankruptcy and criminal history of the issuer’s principal. The settlement included permanent cease and desist orders, a permanent bar from certain investment-related activities, and a $30,000 fine. In light of recent charges like this, fund managers investing in ICOs should ensure they complete adequate due diligence on investment opportunities.

Other

SEC Denies and Delays Bitcoin ETFs

On August 22, the SEC released three separate orders denying nine Bitcoin exchange-traded fund (“ETF”) proposals. These orders followed the SEC’s July 26 denial of another Bitcoin ETF. The SEC’s reasoning in these denials was mainly based on a concern that the price of Bitcoin may be susceptible to manipulation. However, on September 20, the SEC announced that it has begun a formal review for a physically-backed Bitcoin ETF. The acceptance of such an ETF would increase digital asset investment options and has the potential to promote the overall growth of the industry.

SEC Suspends Trading of Swedish Bitcoin Instruments

On September 9, the SEC temporarily suspended trading of two foreign cryptocurrency investment instruments commonly known as the “Swedish Bitcoin ETFs”. The instruments hold Bitcoin on behalf of shareholders and, prior to the suspension, had been tradable in U.S. brokerage accounts. The SEC suspended the ETFs out of a concern for investor confusion, which was likely based on inconsistent representations. The issuers’ broker-dealer applications referred to the instruments as ETFs, other sources characterized them as exchange-traded notes, and the issuers’ offering memoranda described them as “non-equity linked certificates”. With this suspension in mind, fund managers considering investing in novel digital asset instruments should ensure they understand the nature of the instruments.

CFTC MATTERS

Investor Alerts

CFTC Stresses Due Diligence in ICO Investments

On July 16, the Commodities Futures Trading Commission (“CFTC”) published an alert cautioning investors to conduct extensive research before investing in any ICO, especially those that claim to be utility tokens (i.e. non-securities). The alert includes factors that investors should consider before investing in a token offering, such as the potential for forks, mining costs, liquidity, and risk of hacks.

Enforcement

Court Enters Final Order for CFTC Charges Against Crypto Company

On August 23, a New York federal court entered final judgment against a digital asset company based on charges brought by the CFTC. The company claimed that, in exchange for sending digital assets, customers could receive expert crypto trading advice or have the company trade on their behalf. However, no such expert advice or trading services were provided. The company was charged with fraud and the final judgment included a permanent injunction from certain investment-related activities, more than $290,000 in restitution, more than $871,000 in civil penalties, and post-judgment interest.

NFA MATTERS

NFA Requires CPOs and CTAs to Disclose Digital Asset Activity

On July 20, the National Futures Association (“NFA”) released a notice that imposed new disclosure requirements on futures commission merchants, commodity pool operators (“CPOs”), and commodity trading advisers (“CTAs”) engaged in digital asset activity. Specific to CPOs and CTAs, the NFA is now requiring discussion of certain aspects of digital asset investing, such as volatility, liquidity, and cybersecurity, as well as the inclusion of certain standardized disclosures. Additional details are available in our recent blog post.

FINRA MATTERS

FINRA Charges Broker with Fraud and Unlawful Distribution for Token Offering

On September 11, the Financial Industry Regulatory Authority (“FINRA”) charged a broker in connection with a token offering. The broker attempted to raise money through the offering for an allegedly worthless public company and, in the process, misled investors about the company’s operations and finances. The broker is charged with making material misrepresentations, offering and selling unregistered securities, and failing to notify the broker’s firm about the transactions. This is FINRA’s first disciplinary action involving digital assets.

FEDERAL LEGISLATION

Congressional Representative Introduces Crypto-Friendly Bills

On September 21, Minnesota Congressional Representative Tom Emmer announced three crypto-friendly bills. The first bill would codify an overall “light touch, consistent, and simple” approach to digital asset regulation. The second bill would provide a safe harbor for certain businesses that lack control over consumer funds by exempting them from certain regulations, such as money transmitter licensing requirements. Lastly, the third bill would limit fines for taxpayers that failed to fully report forked digital assets until the Internal Revenue Service (“IRS”) provides further guidance on how such forks should be reported.

STATE MATTERS

New York

New York Attorney General Releases Report on Digital Asset Exchanges

On September 18, the Office of the Attorney General of New York (the “OAG”) released a report summarizing a crypto exchange fact-finding initiative. The report outlines three primary areas of concern:

  • Conflicts of Interest – Crypto exchanges are exposed to potential conflicts of interest in several ways. For example, exchanges often have additional lines of business (e.g. broker-dealer) that would either be prohibited or carefully monitored in traditional securities contexts. Additionally, employees may have access to non-public information, and may hold and trade digital assets on their employer’s or competitors’ exchanges. Some exchanges also lack standards for determining which tokens are listed, and the possibility that an exchange may take fees for such a listing create a potential conflict of interest.
  • Lack of Anti-Abuse Efforts – Digital asset exchanges have not consistently implemented safeguards to protect the integrity of their platforms. Such safeguards include monitoring real-time and past trades, and restricting the use of bots. Additionally, some exchanges engage in proprietary trading (i.e. trading from the exchange’s own account in order to, for example, promote market liquidity) which may expose users to price manipulation or other abuse.
  • Limited Customer Funds Protections – Exchanges lack a consistent and transparent approach to auditing the digital assets they hold. Additionally, several exchanges do not have independent audits completed. These shortcomings make it difficult to determine whether crypto exchanges adequately maintain and protect customers’ assets. The OAG also raised concerns over whether exchanges have adequate protection against hacks and maintain sufficient insurance policies.

Digital asset fund managers should keep these concerns in mind and ensure they properly vet exchanges they may utilize.

Court Rules ICO Tokens May Be Subject to Securities Laws

On September 11, the U.S. District Court for the Eastern District of New York ruled that a criminal case brought against the individual behind two ICOs can proceed to trial. The defendant faces conspiracy and securities fraud charges for allegedly making false claims that the tokens sold in the ICOs were backed by real estate and diamonds. The defendant moved to dismiss the case on the grounds that securities laws are too vague to apply to ICOs, and that the issued tokens were not securities. The issue of whether the tokens in question are securities may now ultimately be decided by a jury.

Texas

Texas Issues Emergency Cease and Desists Against Crypto Investment Scheme

On September 18, the Securities Commissioner of Texas (the “Commissioner”) released three orders related to digital asset investment schemes. First, the Commissioner issued a cease and desist order against a mining company that used promotional materials falsely implying third-party endorsements and associations. Second, the Commissioner issued a cease and desist order against a company that solicited investments to develop a biometric token wallet. The business misled investors with a video of former President Barack Obama that falsely implied he was discussing the company. The business also made unsubstantiated claims, for example, that it was backed by “a leading financial institution”. Lastly, the Commissioner issued a cease and desist order against a company that solicited investments for its crypto and forex trading programs. The company told investors they could earn 10x returns, that those returns were guaranteed, and that there was no investment risk. All orders allege that the companies violated securities laws by offering and selling unregistered securities, engaging in fraud, and making materially misleading statements. These orders further highlight the need for fund managers to conduct due diligence on digital asset investment opportunities.

OTHER MATTERS

Statements

Congressional Representatives Urge IRS to Provide Guidance on Cryptocurrency

On September 19, five members of the House of Representatives published a letter urging the IRS to issue updated guidance on digital asset taxation. The last major guidance from the IRS, Notice 2014-21, was issued in March 2014. Since then, the IRS has increased digital asset scrutiny by, for example, requesting transaction records from crypto exchanges and choosing not to provide leniency through a voluntary crypto disclosure program. Such guidance would hopefully resolve some of the tax uncertainties digital asset fund managers currently face.

NASAA Announces Coordinated Digital Asset Investigations

On August 28, the North American Securities Administrators Association (“NASAA”) announced that regulators in the U.S. and Canada are engaged in more than 200 digital asset-related investigations as part of a coordinated NASAA initiative known as “Operation Cryptosweep”. While investigations have focused on suspected securities fraud, regulators have uncovered other violations, such as the offer and sale of unregistered securities. The initiative has resulted in at least 46 enforcement actions related to ICOs or digital asset investment products.

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Bart Mallon is a founding partner of Cole-Frieman & Mallon LLP. Cole-Frieman & Mallon LLP has been instrumental in structuring the launches of some of the first digital currency-focused hedge funds and works routinely on matters affecting the digital asset industry. Mr. Mallon can be reached directly at 415-868-5345

Airdrops and Securities Laws

Legal Issues Surrounding Digital Asset Airdrops

Given the regulatory scrutiny on initial coin offerings, many digital asset company sponsors (those launching an ICO token/product/security/utility/etc) have been looking for ways to get their assets in the hands of a large number of people to begin creating network effects so the digital asset become valuable.  One way to accomplish this is through an “airdrop” where the sponsor gives away the digital asset to certain persons under certain circumstances.  Airdrops come in many shapes and forms – in some, the sponsor deposits only the digital asset they have created and in others a sponsor or other third party might deposit a variety of digital assets created by different groups.  Some airdrops require users to do something (sign up for a list or tweet a link related to the sponsor) and some are done for “free”.  In any event, there are potentially securities laws issues related to the airdrops and any transactions in the digital asset after the airdrop.  The below analysis is intended as a broad overview, but each airdrop should be considered in light of its facts and circumstances.  Additionally, the regulation of airdrops, including how they may be taxed, is beginning to evolve and subject to change.

Potential Application of Securities Laws to Airdrops

The legal status of digital assets is uncertain and continually developing – whether a token is a security ultimately depends on the particulars of each token.  Given recent statements by the SEC, however, it is safest to assume that any airdropped tokens are securities.  The public offering or sales of securities must be registered with the SEC or qualify for an exemption, though many token companies are not complying with these requirements.  As a result, a number of these airdrops may be violating securities laws, even if the teams behind the assets claim they are not securities, or if they do not realize their activities fall within the scope of the securities laws.  In light of this, the following legal issues may apply to an airdrop:

  • Transfer Restrictions – Even if a token qualifies for an exemption from registration with the SEC, it may be subject to transfer restrictions. For example, many securities are exempt from SEC registration via the private placement exemption under Regulation D (also known as “Reg D”), which requires a certain holding period (e.g. 6-12 months) before a purchaser can transfer the securities.  While the Reg D exemption applies to purchases and sales of securities, the Reg D holding restrictions may apply because the SEC may view the exchange of personal information and/or public promotion as payment.  In light of this, the recipients of digital assets (unknowingly) may be restricted from transferring those assets and should be careful.
  • Free Stock Enforcement Actions – In the late 1990’s the SEC brought enforcement actions in cases of “free stock” offerings. In such instances, companies gave out “free” stock in exchange for something of value to the company.  For example, recipients provided personal information, solicited additional investors, and linked to issuers’ websites.  The SEC was concerned that investors were not receiving full and fair disclosures about the securities.  Airdrops resemble free stock since the airdrop teams give “free” tokens, often in exchange for information like email addresses or social media shares.  Additionally, these airdrop programs are often promoted in mediums such as Telegram chats where disclosures are entirely absent.  Because of these similarities with free stock, the SEC could bring enforcement actions against the sponsors of the airdrops in the future.
  • Broker-Dealer Regulations – Generally, a broker is anyone that engages in securities transactions on behalf of another person for compensation, and must be registered with the SEC. If a team airdrops digital assets on behalf of other token companies, it could be deemed a broker if it receives compensation for the airdrop.  This compensation could take the form of tokens or marketing services from issuers of the airdropped assets.
  • Underwriter Liability – An underwriter is someone that acts on behalf of a securities issuer, for example, by distributing securities of the issuer. Depending on the circumstances, underwriters can be liable for an issuer’s securities violations.  If an airdrop team deposits tokens that are issued by another company, it could also be liable for the securities violations of that company, which very well may be the case, as described above.
  • Pump & Dump – Pump and dump schemes occur when an organized group coordinates to artificially change the price of an asset. The SEC and CFTC have issued warnings about token pump and dump schemes, and the SEC has already pursued certain groups for these schemes.  In light of this, airdrop announcements and marketing materials will likely be subject to heightened scrutiny by the SEC and CFTC.
  • KYC/AML – Know Your Customer (“KYC”) and Anti-Money Laundering (“AML”) laws are aimed at combatting money laundering and bribery and require certain due diligence on clients. KYC and AML regulations typically apply to banks, broker-dealers, FINRA members, and other financial institutions, as well as large cash transactions.  Many token exchanges already implement KYC and AML procedures, for example, by requiring new users to upload a driver’s license in order to prove their identities.  It’s possible that an airdrop team may be subject to KYC and AML requirements such that it would need to verify the identity of each recipient.

Conclusion

As the digital asset industry becomes more aware of the securities laws and the nuances of the application of those laws to the digital asset space, sponsors of digital assets are working to make sure their business plan and token distribution structure fit within the laws.  While airdrops (“free tokens”) seem like one way to get around certain securities laws, there are still risks and sponsors should vet any potential distribution, even if free, with legal counsel.  We do expect to see a wider variety of token offering structures used in the future, including Regulation A+ which has fewer restrictions on securities transfers.

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Bart Mallon is a founding partner of Cole-Frieman & Mallon LLP.  Cole-Frieman & Mallon LLP has been instrumental in structuring the launches of some of the first digital currency-focused hedge funds and works routinely on matters affecting the digital asset industry.  Please contact Mr. Mallon directly at 415-868-5345 if you have any questions on this post.