Implications of SEC’s Move on EtherDelta and Beyond

Disclaimer: This post does not constitute legal advice and does not create an attorney-client relationship. If you require compliance advice, please contact Spartan Compliance directly.

The U.S. Securities Exchange Commission (“SEC”) has issued a cease and desist order, charging EtherDelta founder Zachary Coburn with operating an unregistered securities exchange (hereafter ‘order’). The order is one of the first to target crypto-exchanges directly. We believe that the enforcement decision has a number of compliance implications for crypto-exchanges in the U.S. and serves as a reminder for crypto-exchanges looking to set up their operations in the U.S.

Key takeaways from the SEC’s order:

• This order is yet another move in the series of orders issued by the SEC that continues to signal the increasing difficulties participants in the crypto-markets are met with when attempting to set up their operations in the U.S.
• The order should come as no surprise given the clear implications of the Report of Investigation Pursuant to Section 21(a) of The Securities Exchange Act of 1934: The DAO, which laid out a clear position on how digital tokens will be considered to be securities for the purposes of the Securities and Exchange Act. The order should be seen as a warning sign for all the U.S.-operating exchanges that wilfully ignored the Report’s implications. Indeed, apart from bitcoin and ether, it seems that any tokens can be considered securities by the SEC.
• The order shows the SEC’s clear understanding how a DEX operates. The SEC’s focus is the security tokens as an asset class and the related activities, not on DEX functioning per se. The SEC takes issue with the fact that ‘there are no rules set forth in the smart contract that limit a user from trading any particular ERC20 token on EtherDelta’. In other words, the issue is with some of the 500+ tokens listed being securities (see Order para 26 in particular). Having an open listing akin to EtherDelta’s would not be advisable going forward, as the liability for facilitating the buying and selling of securities remains with the DEX (and potentially DEX founders / contributors), even though the listings were done by its users.

On securities regulation and crypto-exchanges:

• The implication on the listing and trading of tokens construed as securities on U.S. crypto-exchanges is clear: no token is off-limits for SEC supervision.
• The focus on crypto-exchanges in general is warranted, especially in view of prior rumours that the SEC will increasingly focus on crypto-exchanges. This is a clear signal to all crypto-exchanges in the U.S. of substance over form — you are under the purview of SEC if you fall within the statutory definition of an exchange that deals in securities.
• SEC’s order is indicative of a seeming disarray between the federal licensing regimes, such as New York’s BitLicense and the SEC’s approach to regulating crypto-exchanges. We have always believed that intra-governmental alignment and cooperation on crypto-related matters is absolutely crucial.
• The relevance of the SEC’s order should not be overstated, as the statutory definition of ‘security’ differs among jurisdictions and should be analyzed on a case-by-case basis.
• For future crypto-exchange operators, what will be of crucial importance is determining whether the SEC has extra-territorial jurisdiction over crypto-exchanges that are registered outside of the U.S., but continue allowing U.S. citizens to trade.

Implications for the regulation of a DEX and operational implications:

• Historically, decentralization in the crypto-sense has not been perceived as a concept of legal importance or relevance per se. As a matter of fact, it is only following the public discussion of the Howey test application, that the word has gained a seeming legal importance. Within the context of a DEX, the concept of decentralization is only relevant for the purposes of applying the Howey test (in particular, ‘…the efforts of the promoter or a third party…’).
• There is potentially more than meets the eye in the ruling, and EtherDelta may have been another ‘low-hanging fruit’ move by the SEC. The order should not be seen as a direct assault at decentralized exchanges in general. There is nothing in the order that would suggest this.
• Instead, the order is a signal that, for the purposes of SEC’s purview, what is ‘an exchange’ has a broad meaning and a mere presumption that a DEX will fall outside of the definition is wrong. Indeed, EtherDelta met the functional definition of what is an exchange. This should serve as a reminder for prospective developers hoping to set up their DEX that instead of focusing on ‘how to circumvent securities regulation’, they should instead be paying close attention to statutory definitions and the rationale behind exchange regulation.

Implications for the market:

• The cryptocurrency market has reacted surprisingly calmly to the SEC action against EtherDelta thus far. Some industry experts have commented that the size of the fine does not seem too harsh. We believe this is missing the point. We believe EtherDelta will likely be the first in a string of enforcement actions against other crypto-exchanges that have committed similar violations of U.S. securities regulations. Based on past actions, the SEC tends to go for easy wins early on and work its way to bigger offenders over time, so we should expect to see more aggressive enforcement actions in the coming months.
• The SEC’s order will likely push many current and future crypto-exchanges to operate outside of the U.S., e.g. to Japan, Hong Kong, Singapore and Malta which are more crypto-friendly jurisdictions. As another example, the Securities and Futures Commission of Hong Kong (“SFC”) recently announced the creation of a sandbox for crypto-exchanges.

Compliance implications:

• The presumption that an exchange is designed and operated by a decentralized network does not absolve individuals of prospective liability. Coburn left EtherDelta prior to the order and his departure did not absolve him from responsibility — the SEC has the power to target a specific person and a specific period.
• What should be carefully analyzed is the extent to which those merely writing and executing code (e.g. the developers behind a DEX) are now vulnerable to legal action if they, for example, neglect embedding a filtering of security tokens.
• Zachary Coburn agreed to pay a total of $388,000 in penalties, disgorgement and interest under the settlement (and further civil lawsuits cannot be ruled out)
• The implications of the EtherDelta enforcement action signifies the SEC’s commitment towards regulating decentralized businesses transacting and/or holding virtual assets.
• Crypto and blockchain businesses are becoming more susceptible to regulatory frameworks derived from the traditional finance sectors, including securities and Anti-Money Laundering and Countering the Financing of Terrorism (AML/CFT) laws (including BSA, FCPA and OFAC).
• In addition to the application of securities law to cryptocurrencies by the SEC, the Financial Action Task Force (“FATF”) — the leading intergovernmental body that enforces AML regulations worldwide — has also recently extended its FATF 40 Recommendations to include decentralized businesses.

As mentioned above, the EtherDelta decision as a whole should not come as a surprise, although as with any case it has its own unique twists and turns. Our key takeaway is that regulatory compliance is now more important than ever. Should you have any compliance needs, please reach out to us on info@spartangroup.io.