Escaping the sandbox: a legal examination of the U.S. regulatory approach to crypto and initial coin offerings

Intro

While there are several government agencies and regulatory bodies that have weighed in on the subject, this article will focus on recent SEC precedent regarding ICOs and cryptocurrency regulatory enforcement. In order to provide some context, we will first briefly examine the regulatory and governmental climate generally. The White House expressed in February 2018, that the U.S. will not authorize any further cryptocurrency regulation “anytime soon.” [1] Instead — to this point — the U.S. government has debatably taken a “regulatory sandbox approach” to cryptocurrency regulation.[2] In other words, to avoid impeding growth within the blockchain space, U.S. regulators have vowed to take a “no harm approach” to cryptocurrency regulation.[3]

In theory, a “regulatory sandbox” approach would allow time for regulators to perform more industry research and gain a more complete understanding of the industry before enacting any new rules or regulations. For example, Chairman Giancarlo of the CFTC stated, “We owe it to this new generation to respect their enthusiasm for virtual currencies, with a thoughtful and balanced response, and not a dismissive one.” [4] Furthermore, the SEC has neither enacted or proposed any crypto-specific rules or regulations, nor has the SEC provided substantive interpretative guidance with respect to the regulation of cryptocurrencies.[5] In its place, the SEC has brought several enforcement actions against ICOs. In doing so, the SEC has effectively attempted to draw a line in the sand indicating where the definition of a security begins and ends with regard to cryptocurrencies and blockchain-backed smart tokens. Therefore, while the U.S. government seems to recognize the inherent value in encouraging growth within the blockchain community, the SEC has provided clear guidance on the topic of whether an ICO is actually an offering of securities. But one thing is for certain, the process has only just begun.

SEC Focus

As stated briefly above, the SEC has yet to adopt any new specific regulations regarding cryptocurrencies or ICOs.[6] Instead, the SEC’s regulatory involvement has been limited to circumstances that involved the unregistered sale or solicitation of securities. Additionally, as we will discover below, the majority of cases brought against ICOs have also involved numerous other securities violations, including fraud and material misrepresentation.

The SEC analysis begins, not surprisingly, with the definition of “security” under the Securities Act of 1933 (the “Securities Act”) and Securities Exchange Act of 1934 (the “Exchange Act”).[7] Section 2(a)(1) defines a “security” as:

any note, stock, treasury stock, security future, security-based swap, bond, debenture, evidence of indebtedness, certificate of interest or participation in any profit-sharing agreement, collateral-trust certificate, preorganization certificate or subscription, transferable share, investment contract, voting-trust certificate, certificate of deposit for a security, … or, in general, any interest or instrument commonly known as a “security.” [8]

While it is true that ICOs often behave like securities, cryptocurrencies generally, often do not. However, the definition of a security has proven itself to be broad enough to grant the SEC sweeping authority to regulate a variety of products as securities. For example, in some instances, the SEC has claimed that initial coin offerings were “investment contracts” under the “Howey test.”[9] In the U.S. Supreme Court case SEC v. W. J. Howey Co., the Court held that an investment contract is a contract, transaction, or scheme involving

“(i) an investment of money, (ii) in a common enterprise, (iii) with the expectation that profits will be derived from the efforts of the promoter or a third party.”[10]

The Howey test provides for a broad regulatory scope and covers a wide range of offerings, investment schemes, and non-traditional asset classes not specifically foreseen at the time of its decision. [11]

The astonishing speed at which blockchain payment systems technology is being adopted and utilized by investors poses a number of regulatory challenges for the industry. This has put increasingly high pressure on regulators to ensure that bad actors cannot find solace, or easy prey, within the cryptocurrency space. While this responsibility does not lie with the SEC alone, the technical definition of a “security” does not completely define the SEC’s role. Instead, the SEC has reminded the industry that their duties are more general —

“(i) protect investors, (ii) maintain fair, orderly, and efficient markets, and (iii) facilitate capital formation.”[12]

The SEC defines cryptocurrencies broadly as tokens that “purport to be items of inherent value (similar, for instance, to cash or gold) that are designed to enable purchases, sales and other financial transactions.”[13] The SEC explains further that they are “intended to provide many of the same functions as long-established currencies such as the U.S. dollar, euro or Japanese yen but do not have the backing of a government or other body.”[14]

There are four factors that regulators have identified as being consistent attributes of cryptocurrencies, including:

“(1) the ability to make transfers without an intermediary and without geographic limitation, (2) finality of settlement, (3) lower transaction costs compared to other forms of payment and (4) the ability to publicly verify transactions.”[15]

As mentioned briefly above, the SEC has maintained that cryptocurrencies do not inherently appear to be securities.[16] However; simply calling a blockchain based product a “cryptocurrency” does not necessarily exempt the product from securities laws.[17] For example, the SEC has clarified that:

“[before launching] a cryptocurrency or a product with its value tied to one or more cryptocurrencies, its promoters must either (1) be able to demonstrate that the currency or product is not a security or (2) comply with applicable registration and other requirements under our securities laws.”[18]

Furthermore, market participants that allow for payments in cryptocurrencies or use cryptocurrencies to enable securities transactions must exercise extreme caution and ensure that their cryptocurrency activities are not “undermining their anti-money laundering and know-your-customer obligations.”[19]

Therefore, while the SEC has delegated much of the responsibility for regulating cryptocurrencies to the CFTC, they have yet to approve any “exchange-traded products (such as ETFs)” that hold cryptocurrencies or other digital assets for listing or trading.[20] The SEC issued an investor bulletin about initial coin offerings in July 2017, stating that the Commission believes that cryptocurrencies have the potential to be “fair and lawful investment opportunities” if regulated properly.[21] But the SEC has aggressively prosecuted entities and individuals that have employed fraudulent or deceptive means to gain investors and has issued several enforcement actions against “ICO sponsors.” The SEC Chairman, Jay Clayton, has clearly “expressed concern about market participants who extend to customers credit in U.S.” [22] The SEC has a clear dislike for ICOs, and this position was made clear by Clayton in February 2018 when he stated:

“From what I have seen, initial coin offerings are securities offerings. They are interesting companies, much like stocks and bonds, under a new label.”[23]

He continued, “You can call it a coin, but if it functions as a security, it is a security.”[24]

Clayton’s major concerns stem from the lack of regulatory oversight in the cryptomarkets and he believes that “many ICOs are being conducted illegally by not following securities laws.”[25] He concluded by cautioning the ICO marketplace that “those who engage in semantic gymnastics or elaborate structuring exercises in an effort to avoid having a coin be a security are squarely within the crosshairs of our enforcement division.”[26] However, Clayton was not negative on the industry as a whole, as he also stated that he “think[s] this distributed ledger technology has enormous potential… [and he] hope[s] people pursue it vigorously.”[27]

ICO Crackdowns

Understandably, the SEC is much more concerned with ICOs than traditional cryptocurrencies like Bitcoin or Ethereum. An Initial Coin Offering (“ICOs”) is an effective tool being used in conjunction with cryptocurrencies to raise capital. Generally, these offerings involve an investment opportunity to exchange FIAT or cryptocurrencies for a digital coin or token that will be developed — the expectation typically being that investor funds will be used to develop such digital coin. As made clear by the excerpts above, the major question for ICO investors, developers, and SEC regulators is whether the ICO a security. As I am sure you are expecting, the answer is: “it depends.” The SEC published a public statement on their website entitled “Statement on Cryptocurrencies and Initial Coin Offerings” on December 11, 2017.[28] Within this statement, Chairman J. Clayton provided the following guidance on how to determine whether a particular token should be considered a security for securities law purposes:

[A] token that represents a participation interest in a book-of-the-month club may not implicate our securities laws, and may well be an efficient way for the club’s operators to fund the future acquisition of books and facilitate the distribution of those books to token holders. In contrast, many token offerings appear to have gone beyond this construct and are more analogous to interests in a yet-to-be-built publishing house with the authors, books and distribution networks all to come. It is especially troubling when the promoters of these offerings emphasize the secondary market trading potential of these tokens. Prospective purchasers are being sold on the potential for tokens to increase in value — with the ability to lock in those increases by reselling the tokens on a secondary market — or to otherwise profit from the tokens based on the efforts of others. These are key hallmarks of a security and a securities offering.[29]

Essentially, the main point that the SEC is making is that the fact that the technological structure behind a securities offering may be changing does not change the need to abide by applicable securities laws. Technology is constantly changing the way we do things, and the SEC understands the need to encourage and support technological growth and innovative projects surrounding the capital raising space. However, if that innovative activity involves an offering of a security it must be accompanied by the necessary “disclosures, processes and other investor protections that our securities laws require.” [30] This represents the old regulatory adage that prioritizes substance over form. From the perspective of the SEC, whether a company or individual is using a central ledger or recording securities interests through a distributed ledger using blockchain, the substance of the transaction remains the same. Thus, the SEC and other relevant government actors remain focused on identifying the underlying purposes behind each ICO or blockchain-backed transaction.

As stated above, the SEC has brought a plethora of enforcement actions that offer only a partial degree of regulatory guidance. However, in lieu of having such guidance, we must attempt to glean as much as possible from the growing number of enforcement actions being brought against cryptocurrency market participants. Below, I have provided an analytical summary of a collection of recent and highly relevant SEC actions against ICOs:

1. AriseBank

AriseBank purported itself to be the world’s first “decentralized bank,” supposedly offering an assortment of commercial banking products and services, and supporting “more than 700 different virtual currencies.”[31] The fraudulent entity claimed to be “one of the largest cryptocurrency platforms ever built,” and was supposedly “focused on bringing cryptocurrency to the average consumer and using it to revolutionize banking.”[32] AriseBank raised money through an ICO of its own cryptocurrency called “AriseCoin,” through which AriseBank claimed to have raised more than $600 million.[33] AriseBank made several material misrepresentations in connection with their ICO, including announcing that it had “purchased a 100-year-old commercial bank” and claiming that AriseBank could now “offer FDIC-insured accounts and transactions,” all of which being completely false. [34] The SEC charged AriseBank with securities laws violations due to the company’s failure to disclose their financial information through the registration of securities process with the SEC.[35] This was the SEC’s dream case. Not only was this an unauthorized sale of securities, but company officials lied repeatedly in connection with their ICO. This is an example of an obvious attempt to take advantage of cryptocurrency enthusiasts and inexperienced investors through fraudulent means. However, the lessons learned from this case are limited in terms of their application. It is generally known that making fraudulent statements in connection with an unregistered offering of securities is not allowed.

2. Plexcoin

On December 1, 2017, the SEC filed an emergency action to stop Lacroix and his partner Paradis-Royer from further misusing of funds raised illegally through an unregistered ICO of securities called “PlexCoin” or “PlexCoin Tokens.”[36] Over a 6 month period, the defendants raised $15 million from thousands of investors through materially false and misleading statements.[37] Lacroix promised investors an ROI (return on investment) of 1,354% in less than a month. The defendants proceeded to “misappropriate investor funds and engage in other deceptive acts relating to investments in the PlexCoin.” [38] For example, Lacroix claimed: “(a) that the PlexCorps’ “team” consisted of a growing cadre of experts stationed around the world and with a principal place of business in Singapore; (b) that the identity of PlexCorps’ executives had to be kept hidden to avoid poaching by competitors and for privacy concerns; © that the proceeds of the PlexCoin ICO would be used to develop other PlexCorps products; and (d) that investors could expect “enormous” and “real” returns on PlexCoin Token investments.”[39] All of the above statements were later proven to be false. Furthermore, the defendants have misappropriated more than $200,000 of investor funds on “extravagant personal expenditures,” while the rest was used to purchase Bitcoin. [40] Similar to the AriseBank case, these defendants committed fraud in connection with an unregistered sale of securities.

3. REcoin

On September 29, 2017, the SEC filed an emergency action against Zaslavskiy and his company, REcoin, for “engaging in illegal unregistered securities offerings and ongoing fraudulent conduct and misstatements designed to deceive investors in connection with the sale of securities in so-called [ICO].”[41] Zaslavskiy fraudulently raised at least $300,000 from hundreds of investors, through various material misrepresentations. In connection with the ICO, the defendant claimed: “(i) that investors were in fact purchasing digital “tokens” or “coins”; (ii) that Defendants had raised more than $2 million, and, later, nearly $4 million, from the REcoin ICO; (iii) that REcoin had a “team of lawyers, professionals, brokers, and accountants” that would invest REcoin’s ICO proceeds into real estate and that Diamond had “experts” to select the best diamonds; (iv) that REcoin had to shut down because the U.S. Government had forced it to do so; and (v) that investors in the REcoin ICO could expect to make returns from REcoin’s investments in real estate and that investors in the Diamond ICO could expect to make 10–15% returns from Diamond’s operations.” [42] All of these assertions were false. Furthermore, in an attempt to further “skirt the registration requirements of the federal securities laws,” Zaslavskiy modified the sale of the supposed “Diamond interests as sales of memberships in a club and the Diamond ICO as an ‘Initial Membership Offering’ or IMO.” [43] These attempts were unsuccessful. The SEC rightly recognized that the funds were still being raised fraudulently and in connection with “tokens” that did not actually exist, and thus, required SEC registration.[44]

Conclusion

The SEC has effectively enforced the securities laws against fraudulent ICOs, but there are still major areas of concern that have yet to be completely addressed. Therefore, for now, individuals operating in the blockchain and cryptocurrency market should keep current on SEC developments and new precedent in order to avoid unknowingly committing securities violations.

Resources

[1] Annaliese Milano, Crypto Regulation? Not Anytime Soon, Says White House Official, Coindesk.com (February 16, 2018), available at: https://www.coindesk.com/crypto-regulation-not-anytime-soon-says-white-house-official/

[2] See Richard B. Levin et al, Real Regulation of Virtual Currencies, Handbook of Digital Currency, 328–31(2015).

[3] Lucinda Shen, Bitcoin Traders Are Relieved at CFTC and SEC Cryptocurrency Senate Hearing Testimony, Forbes (February 7, 2018), available at: http://fortune.com/2018/02/06/bitcoin-price-cftc-sec-cryptocurrency-hearing/

[4] Id.

[5] See Richard B. Levin et al, Real Regulation of Virtual Currencies, Handbook of Digital Currency, 328–31(2015).

[6] See Richard B. Levin et al, Real Regulation of Virtual Currencies, Handbook of Digital Currency, 328–31(2015).

[7] Securities and Exchange Act of 1933 § 2(a)(1)

[8] Securities and Exchange Act of 1933 § 2(a)(1)

[9] See e.g., SEC v. Shavers, №4:13-CV-416; see also In the Matter of Voorhees, Securities Act Release No,3–15902 (June 3, 2014), available at: https://www.sec.qov/litiqation/litreleases/2014/lr23090.html

[10] SEC v. W.J. Howey Co., 328 U.S. 293, 298–99 (1946).

[11] See id.

[12] Michael S. Piwowar, Acting Chairman, SEC, Remarks at the “SEC Speaks” Conference 2017: Remembering the Forgotten Investor (Feb. 24, 2017), available at: https://www.sec.gov/news/speech/piwowar-rememberinq-theforqotten-investor.html

[13] SEC Chairman Jay Clayton, Public Statement on Cryptocurrencies and Initial Coin Offerings, U.S. Securities and Exchange Commission (Dec. 11, 2017), available at: https://www.sec.gov/news/public-statement/statement-clayton-2017-12-11

[14] SEC Chairman Jay Clayton, Public Statement on Cryptocurrencies and Initial Coin Offerings, U.S. Securities and Exchange Commission (Dec. 11, 2017), available at: https://www.sec.gov/news/public-statement/statement-clayton-2017-12-11

[15] SEC Chairman Jay Clayton, Public Statement on Cryptocurrencies and Initial Coin Offerings, U.S. Securities and Exchange Commission (Dec. 11, 2017), available at: https://www.sec.gov/news/public-statement/statement-clayton-2017-12-11

[16] SEC Chairman Jay Clayton, Public Statement on Cryptocurrencies and Initial Coin Offerings, U.S. SECURITIES AND EXCHANGE COMMISSION (Dec. 11, 2017), available at: https://www.sec.gov/news/public-statement/statement-clayton-2017-12-11

[17] SEC Chairman Jay Clayton, Public Statement on Cryptocurrencies and Initial Coin Offerings, U.S. Securities and Exchange Commission (Dec. 11, 2017), available at: https://www.sec.gov/news/public-statement/statement-clayton-2017-12-11

[18] SEC Chairman Jay Clayton, Public Statement on Cryptocurrencies and Initial Coin Offerings, U.S. Securities and Exchange Commission (Dec. 11, 2017), available at: https://www.sec.gov/news/public-statement/statement-clayton-2017-12-11

[19] SEC Chairman Jay Clayton, Public Statement on Cryptocurrencies and Initial Coin Offerings, U.S. Securities and Exchange Commission (Dec. 11, 2017), available at: https://www.sec.gov/news/public-statement/statement-clayton-2017-12-11

[20] Francine McKenna, Here’s How the U.S. and the World Regulate Bitcoin and Other Cryptocurrencies, Dec 28, 2017 11:19 a.m. ET, available at: https://www.marketwatch.com/story/heres-how-the-us-and-the-world-are-regulating-bitcoin-and-cryptocurrency-2017-12-18

[21] Francine McKenna, Here’s How the U.S. and the World Regulate Bitcoin and Other Cryptocurrencies, Dec 28, 2017 11:19 a.m. ET, available at: https://www.marketwatch.com/story/heres-how-the-us-and-the-world-are-regulating-bitcoin-and-cryptocurrency-2017-12-18

[22] Francine McKenna, Here’s How the U.S. and the World Regulate Bitcoin and Other Cryptocurrencies, Dec 28, 2017 11:19 a.m. ET, available at: https://www.marketwatch.com/story/heres-how-the-us-and-the-world-are-regulating-bitcoin-and-cryptocurrency-2017-12-18

[23] Andrew Nelson, SEC and CFTC Give Testimonies at Senate Hearing on Virtual Currencies, Bitcoin Magazine, Yahoo Finance (February 6, 2018), available at: https://finance.yahoo.com/news/sec-cftc-testimonies-senate-hearing-015033442.html

[24] Id.

[25] Id.

[26] Id.

[27] Id.

[28] SEC Chairman Jay Clayton, Public Statement on Cryptocurrencies and Initial Coin Offerings, U.S. Securities and Exchange Commission (Dec. 11, 2017), available at: https://www.sec.gov/news/public-statement/statement-clayton-2017-12-11

[29] SEC Chairman Jay Clayton, Public Statement on Cryptocurrencies and Initial Coin Offerings, U.S. Securities and Exchange Commission (Dec. 11, 2017), available at: https://www.sec.gov/news/public-statement/statement-clayton-2017-12-11

[30] SEC Chairman Jay Clayton, Public Statement on Cryptocurrencies and Initial Coin Offerings, U.S. Securities and Exchange Commission (Dec. 11, 2017), available at: https://www.sec.gov/news/public-statement/statement-clayton-2017-12-11

[31] SEC v. Arise Bank, Civil Action No. [Filed under seal] (January 25, 2018), available at: https://www.sec.gov/litigation/complaints/2018/comp-pr2018-8.pdf

[32] SEC v. Arise Bank, Civil Action No. [Filed under seal] (January 25, 2018), available at: https://www.sec.gov/litigation/complaints/2018/comp-pr2018-8.pdf

[33] Id.

[34] Id.

[35] Id.

[36] SEC v. PlexCorps, Civil Action №17–7007 (December 1, 2017), available at: https://www.sec.gov/litigation/complaints/2017/comp-pr2017-219.pdf

[37] Id.

[38] Id.

[39] Id.

[40] SEC v. PlexCorps, Civil Action №17–7007 (December 1, 2017), available at: https://www.sec.gov/litigation/complaints/2017/comp-pr2017-219.pdf

[41] SEC v. REcoin, Civil №17 Civ. ECF Case (September 29, 2017), available at: https://www.sec.gov/litigation/complaints/2017/comp-pr2017-185.pdf

[42] Id.

[43] Id.

[44] See id.

More where this came from

This story is published in Noteworthy, where thousands come every day to learn about the people & ideas shaping the products we love.

Follow our publication to see more product & design stories featured by the Journal team.