By: Bart Mallon (Co-Managing Partner of Cole-Frieman & Mallon LLP)
Certain Digital Assets are Securities Based on “Facts and Circumstances”
As has been widely anticipated by the cryptocurrency community, the SEC has finally made an initial declaration of the agency’s view that certain digital assets are securities subject to jurisdiction and regulation by the SEC. In a series of four items (press release, investigative report, statement and investor bulletin), the SEC comes out with a strong warning to sponsors of Initial Coin Offerings (ICOs) to be careful of the U.S. securities laws. While many will undoubtedly think the SEC missed a great opportunity to provide robust guidance (and leniency) to the industry, most market participants recognize that this series of discussions was the most likely outcome for many of these instruments (i.e. it is clear that they are securities). Although it is not perhaps what the industry wanted, we at least have *something* to now go by and the industry can begin to figure out how it will structure itself from here.
Below we provide an overview of the various parts of the release as well as some of our observations.
SEC Four Items
The SEC released the following four items today which we describe in greater depth below:
- Press Release 2017-131
- Release No. 81207 (report)
- Divisions of Corporation Finance and Enforcement Statement (July 25, 2017)
- Investor Bulletin: Initial Coin Offerings
Press Release – the release discusses the investigative report it published on The DAO and discusses the investor bulletin created regarding ICOs. The SEC cautions market participants to make sure they examine their activity with respect to ICOs and other structures built on blockchain and distributed ledger technology. Most importantly the release states:
In light of the facts and circumstances, the agency has decided not to bring charges in this instance, or make findings of violations in the Report, but rather to caution the industry and market participants: the federal securities laws apply to those who offer and sell securities in the United States, regardless whether the issuing entity is a traditional company or a decentralized autonomous organization, regardless whether those securities are purchased using U.S. dollars or virtual currencies, and regardless whether they are distributed in certificated form or through distributed ledger technology
SEC Report on the DAO – the report describes the rise and fall of The DAO, discusses how the related facts would be analyzed under the existing securities laws (Howey test), determines that DAO Tokens are securities, and makes the determination that certain “Platforms” are securities exchanges that should be (and should have been) registered with the SEC as securities exchanges. The report ends by listing a number of SEC enforcement actions involving virtual currencies. The SEC also provides the following warning to the industry:
Whether or not a particular transaction involves the offer and sale of a security—regardless of the terminology used—will depend on the facts and circumstances, including the economic realities of the transaction. Those who offer and sell securities in the United States must comply with the federal securities laws, including the requirement to register with the Commission or to qualify for an exemption from the registration requirements of the federal securities laws…These requirements apply to those who offer and sell securities in the United States, regardless whether the issuing entity is a traditional company or a decentralized autonomous organization, regardless whether those securities are purchased using U.S. dollars or virtual currencies, and regardless whether they are distributed in certificated form or through distributed ledger technology. In addition, any entity or person engaging in the activities of an exchange, such as bringing together the orders for securities of multiple buyers and sellers using established nondiscretionary methods under which such orders interact with each other and buyers and sellers entering such orders agree upon the terms of the trade, must register as a national securities exchange or operate pursuant to an exemption from such registration.
CorpFin/Enforcement Statement – the statement basically provides an overview of the U.S. securities regulatory framework and describes how the framework of laws and regulations are designed to protect investors. It discusses the importance of “facts and circumstances” analysis, states that DAO Tokens are securities based on “facts and circumstances” and implores cryptocurrency market participants to seek counsel from private attorneys or the SEC. The statement also warns of bad actors and red flags.
Investor Bulletin – provides background on ICOs, discussed various concepts applicable to the digital asset industry (blockchain, virtual currency, virtual currency exchanges, smart contracts), and discusses the crowdfunding regulations. The bulletin also alerts investors to the issues with getting money back in the event of a scam (tracing issues, international scope of digital assets, the fact there is no central regulator and there is no ability for the SEC to freeze digital assets) and describes the normal things to be careful of that are common in many scams.
The following are some quotes from the various items produced by the SEC which we found interesting, and our thoughts on those quotes.
“Those participating in unregistered offerings also may be liable for violations of the securities laws.”
HFLB: we note that the SEC is intentionally being vague when it references “those participating” – this indicates they will be looking at all parties related to a particular transaction, from sponsors to exchanges to other persons within the ICO distribution chain.
“Additionally, securities exchanges providing for trading in these securities must register unless they are exempt.”
HFLB: here they are basically saying any exchange that DAO Tokens were available on were acting as securities exchanges and needed to be appropriately registered as such.
“The DAO has been described as a “crowdfunding contract” but it would not have met the requirements of the Regulation Crowdfunding exemption because, among other things, it was not a broker-dealer or a funding portal registered with the SEC and the Financial Industry Regulatory Authority.”
HFLB: we find it interesting that the SEC is specifically talking about the crowdfunding regulations. We think that many ICOs / token sales would be good candidates for these platforms (and some tokens have started in that way) and the SEC seems to be highlighting an option for certain fund sponsors. Crowdfunding platforms are regulated by the SEC and FINRA (and do not have as onerous requirements as normal securities registration statements) so they may become an acceptable compromise distribution platform for both ICO sponsors and the SEC.
Report on The DAO
“The United States Securities and Exchange Commission’s (“Commission”) Division of Enforcement (“Division”) has investigated whether The DAO, an unincorporated organization; Slock.it UG (“Slock.it”), a German corporation; Slock.it’s co-founders; and intermediaries may have violated the federal securities laws.”
HFLB: the “sponsors” of The DAO were investigated, which is to be expected. We find it interesting they used the word “intermediaries” which is probably intentionally vague.
“The automation of certain functions through this technology, “smart contracts,” or computer code, does not remove conduct from the purview of the U.S. federal securities laws. This Report also serves to stress the obligation to comply with the registration provisions of the federal securities laws with respect to products and platforms involving emerging technologies and new investor interfaces.” (citations omitted)
HFLB: pretty much what securities lawyers have been saying all along.
“From April 30, 2016 through May 28, 2016, The DAO offered and sold approximately 1.15 billion DAO Tokens in exchange for a total of approximately 12 million Ether (“ETH”), a virtual currency used on the Ethereum Blockchain.” (citations omitted)
HFLB: we believe that the SEC is saying here that Ether is not a security, but is instead a virtual currency. This is important because it shows that some ICOs or digital assets (like ETH) can be instruments other than securities.
“The Commission is aware that virtual organizations and associated individuals and entities increasingly are using distributed ledger technology to offer and sell instruments such as DAO Tokens to raise capital. These offers and sales have been referred to, among other things, as “Initial Coin Offerings” or “Token Sales.” Accordingly, the Commission deems it appropriate and in the public interest to issue this Report in order to stress that the U.S. federal securities law may apply to various activities, including distributed ledger technology, depending on the particular facts and circumstances, without regard to the form of the organization or technology used to effectuate a particular offer or sale.”
HFLB: unfortunately looking to the “facts and circumstances” is all we have here – the SEC is not going to come out with a list of tokens they think our securities so we have to use the “sniff test” to determine whether any particular token is a security. The best advice we have here is to look at the Coinbase Securities Law Framework to come up a best guess.
“The Platforms that traded DAO Tokens appear to have satisfied the criteria of Rule 3b-16(a) and do not appear to have been excluded from Rule 3b-16(b). As described above, the Platforms provided users with an electronic system that matched orders from multiple parties to buy and sell DAO Tokens for execution based on non-discretionary methods.”
HFLB: the SEC is putting those website where DAO Tokens were bought/sold on notice that they were operating as a securities exchange. This will likely give unregistered crypto exchanges pause with respect to many digital asset instruments.
CorpFin / Enforcement Statement
“Market participants in this area must also consider other aspects of the securities laws, such as whether a platform facilitating transactions in its securities is operating as an exchange, whether the entity offering and selling the security could be an investment company, and whether anyone providing advice about an investment in the security could be an investment adviser.”
HFLB: the SEC makes reference to the mutual fund regulations (also applicable to private funds via 3(c)(1) and 3(c)(7) exemptions) as well as the investment advisor regulations, which are applicable to cryptocurrency fund managers.
“Although some of the detailed aspects of the federal securities laws and regulations embody more traditional forms of offerings or corporate organizations, these laws have a principles-based framework that can readily adapt to new types of technologies for creating and distributing securities.”
HFLB: this is exactly why we were surprised that the SEC has not previously issued guidance when it was clear there were other groups who have conducted ICO sales that clearly were securities offerings. The SEC has had the opportunity (and, really, the obligation) to be enforcing the current securities laws in this space and the SEC has specifically chosen not to.
“Finally, we recognize that new technologies also present new opportunities for bad actors to engage in fraudulent schemes, including old schemes under new names and using new terminology. We urge the investing public to be mindful of traditional “red flags” when making any investment decision, including: deals that sound too good to be true; promises of high returns with little or no risk; high-pressure sales tactics; and working with unregistered or unlicensed sellers.”
HFLB: we agree. We fully expect to a number of frauds and other enforcement actions taken with respect to ICOs in the future.
“Although ICOs are sometimes described as crowdfunding contracts, it is possible that they are not being offered and sold in compliance with the requirements of Regulation Crowdfunding or with the federal securities laws generally.”
HFLB: we believe that these various releases will ultimately push more ICOs to look toward crowdfunding platforms for their initial offerings. We also believe that there is the possibility in the future for some sort of digital asset specific crowdfunding platform or a digital asset broker-dealer.
“Ask what your money will be used for and what rights the virtual coin or token provides to you. The promoter should have a clear business plan that you can read and that you understand. The rights the token or coin entitles you to should be clearly laid out, often in a white paper or development roadmap. You should specifically ask about how and when you can get your money back in the event you wish to do so. For example, do you have a right to give the token or coin back to the company or to receive a refund? Or can you resell the coin or token? Are there any limitations on your ability to resell the coin or token?”
HFLB: we believe this guidance is not really helpful for many ICO structures.
“Fraudsters often use innovations and new technologies to perpetrate fraudulent investment schemes. Fraudsters may entice investors by touting an ICO investment “opportunity” as a way to get into this cutting-edge space, promising or guaranteeing high investment returns. Investors should always be suspicious of jargon-laden pitches, hard sells, and promises of outsized returns. Also, it is relatively easy for anyone to use blockchain technology to create an ICO that looks impressive, even though it might actually be a scam.”
HFLB: we agree. We believe it is highly likely there will be a number of scams that will be perpetuated through ICOs.
This is a first step of sorts toward more robust regulation of the digital assets. Although we get some insight from the SEC, we don’t really see anything new and we don’t see how the SEC is going to protect the digital asset markets in the U.S. Instead, this probably plays into fears that the U.S. is not a hospitable jurisdiction to novel ideas and structures and will ultimately push ICOs that would be based in the U.S. to offshore jurisdictions. We hope the SEC uses these statements as a springboard to a dialogue with the industry to keep (and attract) innovators to the U.S. More obviously forthcoming…
For more information on this topic, please see our collection of cryptocurrency fund legal and operational posts.
Bart Mallon is a founding partner of Cole-Frieman & Mallon LLP. Cole-Frieman & Mallon has been instrumental in structuring the launches of some of the first cryptocurrency focused hedge funds. For more information on this topic, please contact Mr. Mallon directly at 415-868-5345.