The Department of Justice and the Securities and Exchange Commission opposed a motion to dismiss filed by a defendant named in a criminal indictment, charging him with offering and selling two types of digital tokens issued in initial coin offerings that the DoJ had alleged were securities without required registration. The defendant had argued that the digital tokens were not securities because they were currencies – albeit cryptocurrencies –, and in any case, were not investment contracts, as charged, under applicable law. Separately, over 95 comments were submitted in response to proposed guidance by the Commodity Futures Trading Commission as to what constitutes actual delivery of a virtual currency to a retail client in a leveraged or financed transaction. As a result, the following matters are covered in this week’s edition of Bridging the Week:
Among other things, Mr. Zaslavskiy claimed in his motion that the digital tokens he tried to create were not securities but cryptocurrencies, and that all currencies, fiat and otherwise, are not securities under applicable law. (Click here for background on Mr. Zaslavskiy’s motion in the article “Federal Court, Treasury and SEC Provide Further Guidance on Cryptocurrencies; Subject of Criminal Complaint for ICO Asks Court to Dismiss Prosecution Claiming Cryptocurrencies Are Not Securities” in the March 11, 2018 edition of Bridging the Week.)
The DoJ argued that the REcoin and DRC ICOs were securities because they were “prototypical” investment contracts. According to the DoJ, applying the landmark Supreme Court decision in SEC v. W.J. Howey Co. (click here to access), each ICO was an investment contact because it represented “an investment of money in a common enterprise with a reasonable expectation of profits to be derived solely from the entrepreneurial or managerial efforts of others.” According to the DoJ, it was irrelevant that no dividends were to be paid to investors; rather, both REcoin and DRC tokens were sold as investments that would increase in value because of the managerial efforts of Mr. Zaslavskiy, and this potential appreciation would be equivalent to a pro rata distribution satisfying the Howey requirement that investors expect profits as a result of their investment.
Although it conceded that currencies are excluded from the definition of currencies, the DoJ said that REcoin and DRC tokens were not currencies solely because they were marketed as cryptocurrencies. Indeed, observed the DoJ, “[t]he superficial resemblance in its label is the only similarity between REcoin/[DRC] and currency.” In its view, currencies under applicable law are only legal tender or something equivalent, “like a cash substitute.”
The SEC generally restated the DoJ’s arguments, although in its supporting brief, it articulated unique challenges ICOs have posed law enforcement agencies in investigating fraud. These challenges include, among other things, the lack of involvement of traditional financial institutions making tracing funds more difficult; the international nature of the blockchain making obtaining and using information from foreign jurisdictions more difficult; a lack of central authority in blockchains forcing the SEC to rely on other sources for information; freezing assets in encrypted wallets is difficult; and the pseudonymous or anonymous nature of the blockchain making it difficult or impossible to identify the attribution of specific digital assets.
Legal Weeds and My View: Although it seems clear that the SEC views most, if not all, ICO-issued tokens to constitute securities, as I have argued before, this analysis seems to overextend the facts and conclusion of Howey, and make so many unlikely things securities.
In Howey, investors purchased land sales contracts and service contracts in connection with orange groves to derive income from the oranges’ harvest and sale by the promoters. This was not a scheme to gain appreciation in the land’s value through resale.
In connection with the sale of REcoin and DRC tokens, investors were only to obtain “profits” through appreciation in the value of their investments. There was no expectation of receipt of dividends or other indicia of income. Thus the reasonable expectation of profits solely through the efforts of others was attenuated at best. This is because very rarely is the price of any cryptocurrency solely (let alone principally) a function of the value of the project underlying the relevant digital token. Although the market perception of the value of a project is, in part, very much relevant to the price of a digital token (i.e., the network effect), so is the price of Bitcoin and other crypto-assets generally, the potential impact of regulation, market and media hype, the perceived utility of a token and the innovation of a token in advancing distributed ledger technology evolution.
Additionally, the SEC’s view of what constitutes an investment contact would make many collectible objects that are hyped by their developers or promoters, including collectible cars and private gold coins, securities. Although there is some precedent for this view (click here to access Marini v. Adamo, a 2014 court decision from a Brooklyn federal court holding in dictum that there was a “factual basis” to find rare coins securities even if this basis had not been stipulated by the parties), it seems a stretch. Very few, if any, owners of 2008 Tesla Roadsters believe they are driving a security.
No malefactor should be able to escape appropriate punishment and/or sanctions because gaps in law are cleverly exploited. It is critical that the SEC, the Commodity Futures Trading Commission and other regulators proactively consider how cryptocurrencies fit within existing laws and legal precedent to not impede beneficial applications of decentralized ledger technology while ensuring customer protection and market integrity. To the extent law must be amended to rationalize regulation and plug gaps, this should be done sooner not later, and in a thoughtful manner that allocates responsibilities among regulators based on specific criteria that define virtual securities, virtual currencies and other crypto-assets.
In response to a CFTC query as to whether 28 days or a shorter period should be the applicable time period, FIA recommended that the Commission “allow the virtual currency markets to continue to develop” before assessing whether a shorter period is appropriate. Alternatively, the National Futures Association indicated that a shorter period is likely prudent because virtual currencies “are offered primarily for speculative investment purposes, are extremely volatile and have attracted a large number of retail participants.” Gemini Trust Company, which operates a virtual commodity exchange, likewise argued that a 28-day delivery window is “unnecessarily long, does not reflect market practices, and may give rise to fraudulent activity.”
Coinbase, which also operates a virtual currency exchange, challenged CFTC suggestions that only virtual currency transactions consummated on a public blockchain should constitute actual delivery. Coinbase observed that such a view “fails to recognize limitations on the capacity of the public ledger.” The firm also indicated that the CFTC suggestion that wallet holders have “unfettered access to digital assets in those wallets” may compromise anti-money laundering and economic sanctions controls, and “unnecessarily” would expose digital assets to cybertheft. The Chamber of Digital Commerce took a different view however, saying that a purchaser should only be deemed to have full control when a seller or offeror exchange delivers the entire quantity of virtual currency to a purchaser’s wallet or its depository/warehouse wallet “away from” the offeror or offeror’s platform. However, the Chamber argued that the Commission “should not require that [a] purchaser hold the private key for a depository wallet so long as the purchaser has access and the ability to move the virtual currency from the depository without restriction by the seller or offeror.”
FIA challenged the CFTC’s assessment that for actual delivery to occur, there must be no liens by an offeror, counterparty seller, or other person acting in concert with the offeror or seller resulting from the use of margin, leverage or financing. FIA argued that the issue of liens “is not relevant” and that the granting of liens is a common practice in the cash commodity and retail markets (e.g., auto loans). Coinbase, however, said that for actual delivery to occur, “[t]he finance or margin provider should not hold any lien on the digital assets or be able to otherwise restrict transfer resulting from the provision of financing or leverage.”
My View: In my own fielding of questions in response to my frequent public speaking on cryptocurrencies, it has become obvious to me that there may not be a uniform appreciation regarding the varied ways transactions in digital assets may be consummated. Today, there are numerous ways for persons to gain access to cryptocurrencies – through peer to peer transactions directly on relevant blockchains; on crypto-exchanges that, in the United States, likely have to be regulated as a money service business by the Financial Enforcement Crimes Network of the US Department of Treasury and money transmitters by most states and that operate mostly off a blockchain; on decentralized exchanges that may combine elements of both peer to peer transactions and off blockchain messages and information flows; and on or through federally regulated facilities such as exchanges and futures commission merchants regulated by the CFTC, and alternative trading systems operated by broker-dealers under the oversight of the SEC. For the CFTC to more meaningfully evaluate important issues related to actual delivery of virtual currencies, it is important to consider each of the different ways to transact in such digital tokens (as well as varied ways persons protect themselves from cyberhacks), as well as what characteristics make a virtual currency not a security under the oversight of the SEC.
My View: Congress’s decision to decrease funding for the CFTC at a time of increased demand for the Commission’s expertise, surveillance and enforcement activity is, in a word, sad. Staff and leadership of the Commission, not to mention the American public, including merchants and producers, who rely on safe and efficient commodity markets, deserve better. Congress’s action is not only a slap in the face of the very capable and dedicated CFTC team, but another example of the dysfunction so manifest on Capitol Hill these days.
For further information:
CFTC Commissioner Condemns Commission Budget Cut:
CFTC Staff Declines CPO Request to Forgo Audit Requirement for Losing Funds Even Where Pool Participants Support Waiver:
Commentators Argue CFTC Proposed Actual Delivery Guidance for Virtual Currencies Requires Refinement:
Department of Justice Argues Against Motion to Dismiss Indictment of ICO Sponsor Claiming That Relevant Digital Tokens Are Securities:
ICE Clear Authorizes Clearing Members to Utilize Banks of Choice to Settle Payments, Not Solely Banks Related to Its Preferred Financial Institutions:
NFA Resolves Disciplinary Action Against Introducing Broker for Failing to Meet Minimum Regulatory Capital Requirements:
SEC Grants Largest Whistleblower Award:
The information in this article is for informational purposes only and is derived from sources believed to be reliable as of March 24, 2018. No representation or warranty is made regarding the accuracy of any statement or information in this article. Also, the information in this article is not intended as a substitute for legal counsel, and is not intended to create, and receipt of it does not constitute, a lawyer-client relationship. The impact of the law for any particular situation depends on a variety of factors; therefore, readers of this article should not act upon any information in the article without seeking professional legal counsel. Katten Muchin Rosenman LLP may represent one or more entities mentioned in this article. Quotations attributable to speeches are from published remarks and may not reflect statements actually made. Views of the author may not necessarily reflect views of Katten Muchin or any of its partners or other employees.