Thursday, November 8, 2018

Operating an Unregistered Digital Tokens Exchange is Unlawful

It didn't come as a surprise that the SEC today published an order announcing a settlement of charges it brought against Zachary Coburn, the founder of EtherDelta, a digital token trading platform.

The SEC has in the recent past brought charges against token issuers for failing to register their token offerings or comply with an available exemption, as well as against platforms for failing to register as broker dealers.  I previously wrote about them here and here.  Today's SEC order is long overdue but is much needed.  It sends a clear signal to the crypto industry that it is not outside of the existing regulations and that all crypto industry participants will be regulated to the extent required by the existing laws.  The crypto exchanges should register just like the traditional exchanges or operate pursuant to an available exemption.

Beginning in July 2016, EtherDelta provided a platform for trading Ether and various digital tokens (about 50), as well as a smart contract that ran on the Ethereum blockchain that was coded to validate the order messages, confirm trade order terms and conditions, execute orders, and update the distributed ledger to reflect the trade.  The website resembled an online securities trading platform.  Users could enter orders to buy or sell specified quantities of any token at a specified price.

The platform continued its operations even after the SEC's DAO Report that was issued on July 25, 2017, where the SEC advised that a platform that provides secondary trading in digital tokens that are securities is required to register with the SEC as a national securities exchange (or be exempt from such regulations).

Although Zachary Coburn posted on Reddit that "his platform function[ed] just like a normal exchange]", it was "decentralized ... Centralized exchanges won't be able to show you verified business logic [in a publicly verified smart contract]".  The decentralized nature of the exchange is not a new argument.  Many of our prospective clients (which never became real clients) claimed that their contemplated crypto exchanges did not need to register due to their decentralized nature. 

Section 5 of the Securities Act prohibits any exchange from effecting any transaction in a security unless registered with the SEC as a national securities exchange or operates pursuant to an exemption.  An "exchange" is defined in Section 3(a)(1) of the Exchange Act (and also the Exchange Act Rule 3b-16(a)) that say that an exchange is "any organization, association, or group of persons, whether incorporated or unincorporated, which .... provides a market place or facilities for bringing together purchasers and sellers of securities...".  One of the exemptions is for alternative trading systems (ATSs) that comply with Regulation ATS (they must, among other things, be registered as broker-dealers, file Form ATS with the SEC, and establish written safeguards and procedures for protecting users' confidential trading information).

The SEC found that "EtherDelta operated as a market place for bringing together the orders of multiple buyers and sellers in tokens that included securities" without registration or exemption, regardless of its decentralized nature.  The SEC also found Coburn to be an active and integral part of EtherDelta who exercised complete control over its operations.

I assume that EtherDelta was never registered as a legal entity.  However, its digital decentralized nature did not prevent the SEC from charging Coburn, the man behind the platform, for operating an unregistered exchange.       

This article is not legal advice, and was written for general informational purposes only.  If you have questions or comments about the article or are interested in learning more about this topic, feel free to contact its author Arina Shulga.  Ms. Shulga is the co-founder of Ross & Shulga PLLC, a New York-based boutique law firm specializing in advising individual and corporate clients on aspects of corporate and securities law.

Sunday, October 21, 2018

Investment Funds Primer - Crypto Funds Overview

I was motivated to write this series of blog posts after attending the NYU Stern FinTech Conference, where I led lunchtime discussion about crypto funds and investing.  In this blog post, I aim to summarize what I see as the state of development of this recently new but quickly growing investment class.   In the next blog post, I will try to explain the regulatory vacuum that allows (and explains) some of this proliferation.

First, let's talk about the statistics so we can understand the magnitude of what is happening.  It is estimated that currently there are 621 crypto funds around the world (a half of them being in the United States), 198 of which were launched in 2017 and a projected 220 in 2018.  Roughly half of the crypto funds (303 out of 621) are small: they have less than $10 million AUM and less than 5 employees.  188 crypto funds have AUM between $10 million and $50 million, and only 37 funds have AUM of over $100 million (such as Pantera Capital, Galaxy Digital Assets, Alphabit Fund, and Polychain Capital).  So, to summarize, 621 crypto funds manage over $7.1 billion, and it is all done by less than 5,000 people globally (most of whom are located in the U.S.).

Now, let's talk about the crypto fund strategies.  Crypto funds are private investment vehicles that raise money to invest into various types of crypto or digital assets.  The main categories are crypto hedge funds and crypto venture capital funds.  Crypto hedge funds act more like typical hedge funds: some actively trade cryptocurrencies on various exchanges, others adopt a buy and hold approach, some are passive index funds that invest in indices of top performing cryptocurrencies, yet others invest into crypto funds of funds, some are AI-driven quant funds that use machine learning to execute statistical arbitrage strategies, and some are token basket funds that invest into baskets of crypto assets.   Crypto venture capital funds invest into ICOs, tokens, and equity of blockchain-related startups.

At this point I would like to briefly summarize the U.S. laws that apply to investment funds generally.  There are no specific regulations yet that apply only to crypto funds. 

The Securities Act of 1933 regulates the process of how the funds can raise investment capital.  Onshore fund offerings are typically conducted in reliance on Regulation D under the Securities Act.  Funds are also subject to the anti-fraud and insider trading regulations under the Securities Act and the Securities and Exchange Act of 1934.  Their disclosures to investors may not contain false or incomplete information.

The Investment Company Act of 1940 (the "Company Act") regulates trading activities of entities that "engage primarily, in the business of investing, reinvesting, or trading in securities" and are "investment companies."  Most traditional hedge funds rely on exemption from the definition of "investment company" found either in Section 3(c)(1) or 3(c)(7) of the Act.  This means that funds either cannot have more than 100 investors or all of investors have to be "qualified purchasers" - a much higher standard of wealth than what is required to be an accredited investor.

The Investment Advisers Act of 1940 (the "Advisers Act") regulates the fund managers that are in the "business of advising others . . . as to the value of securities or as to the advisability of investing, purchasing, or selling securities" and after the Dodd-Frank Act, generally requires them to register with either state agencies or with the SEC.

The Commodities Exchange Act (the "CEA") regulates commodity swaps and other commodity derivatives and investment advisers that advise commodity pools.

As I will explain in the next blog post, some crypto funds escape from most of the current regulations because they do not invest into, or advise on, securities.  The question of what is a "security" becomes paramount.  Investing in  commodities can place the crypto funds outside of regulation of the Company Act, the Advisers Act, and the CEA, thus significantly lowering barriers to crypto fund formation and management.  This helps explain the growth phenomenon of the crypto funds.

This article is not legal advice, and was written for general informational purposes only.  If you have questions or comments about the article or are interested in learning more about this topic, feel free to contact its author Arina Shulga.  Ms. Shulga is the co-founder of Ross & Shulga PLLC, a New York-based boutique law firm specializing in advising individual and corporate clients on aspects of corporate and securities law.

Tuesday, October 9, 2018

Investment Funds Primer: Different Hedge Fund Structures. Part I of Many

As our investment fund practice expands, we have decided to post a series of blogs relating to the basics of hedge fund and private equity fund structuring issues and considerations.

What is a hedge fund?

Hedge funds are often unfairly confused with hedging. “Hedging” is the practice of attempting to reduce risk (similar to getting an insurance), but the goal of most hedge funds is to maximize return on investment. Hedge funds are also often confused with private equity funds. Hedge funds generally invest in publicly traded securities and derivative instruments. Their portfolios can be marked to market. Investors can at any time invest into the funds as well as redeem their interests (subject to limitations, of course). Some hedge funds do invest a portion of their assets in illiquid securities though “side pockets,” but those are less common. Private equity funds, on the other hand, invest in securities of private companies, and therefore are much less liquid. They place significant restrictions on the investors’ ability to invest (only during the subscription period) and exit the fund (mostly only at the expiration of the fund’s term that can be as long as ten years).

Hedge fund structures

Single domestic fund. A stand-along domestic fund is typically a Delaware limited partnership or a Delaware limited liability company. The investors become its members, and the investment managers acts as the fund’s manager or general partner. If the fund is set up as an LLC, the manager receives limited liability protection as a manager of the company, whereas if the fund is set up as an LP, it does not. Therefore, to limit personal liability of the investment manager, it is important to establish a separate investment management entity as an LLC.

In cases where the investment manager will manage only one fund, the investment manager may also act as a general partner of the LP / manager of the LLC. Alternatively, the investment manager may act through its own entity advising various funds. In such case, it becomes necessary for the fund to enter into an investment management contract with the investment manager, in addition to having it or another entity be the general partner / manager of the fund.

Fund of funds. These structures have recently become very popular. Funds of funds are investment vehicles that, instead of investing into securities or other assets, invest into other hedge funds, private equity funds, or other type of funds. Some funds invest across a broad spectrum of assets, including hedge funds, private equity funds, venture capital funds, and real estate funds. Funds of funds provide for maximum diversification of investment and therefore spearing of the risk, as each “portfolio” fund itself invests in multiple assets or securities. It is also easier to invest into funds of funds, as the investment manager can rely on the due diligence done by the managers of the portfolio funds. Further, investing into funds of funds allows investors access to those funds that have high minimum investment amount, thus excluding smaller investors. Note that investing into funds of funds may be more expensive, since the fund of funds’ management fee is layered on top of the management fees of each portfolio fund. It is of course possible for the funds of funds to make direct investments into the underlying funds’ securities in addition to the underlying funds themselves.

Parallel funds. Parallel funds typically involve an onshore fund and an offshore fund that invest directly into the underlying portfolio of assets. The onshore fund has a general partner that itself is a pass-through entity for U.S. federal income tax purposes. The onshore fund pays management fees to the management company and makes an incentive allocation to the general partner. The offshore fund will also pay management fees to the management company, but will also pay an incentive fee to it. Such management company is typically an affiliate of the general partner. Recent tax changes (2008) disallowed the management company to defer the time of the receipt of the incentive fee from the offshore fund, and therefore some offshore funds have created mini-master funds descried below.

The parallel fund structure allows funds to invest differently in the underlying portfolio due to tax or regulatory considerations, although the objective is for the underlying portfolios to be identical.

Master-feeder funds. In a master-feeder structure, each of the onshore and the offshore feeder funds hold an interest in an entity that is treated as a partnership for U.S. federal income tax purposes, the master fund. The master fund invests into the underlying portfolio of assets. Investors in the onshore and the offshore feeders participate in exactly the same investments, and have the same compensation arrangements for the fund managers. In some master-feeder funds, the master fund makes an incentive allocation to its general partner or managing member and pays the management fee to the management company. It is also possible that each of the feeder funds pays a management fee to the management company, and the onshore feeder makes an incentive allocation to its general partner, whereas the offshore fund pays an incentive fee to a management company that is an affiliate of the general partner of the onshore fund.  However, as we mentioned above, this structure is no longer common.

Frequency of redemption requests at the feeder fund level must correspond to the frequency allowed by the master fund, since the money is invested by the master fund and the feeder would need to redeem some of its interest in the master fund in order to meet the redemption request at the feeder fund level.

Typically, the master fund would have a limited number of partners: only the general partner, the onshore feeder, and the offshore feeder.

Parallel funds with mini-master. In this structure, the onshore fund has the same structure as in the parallel funds structure described above. The offshore fund structure, however, has changes. Since it will be treated as a corporation for U.S. federal income tax purposes, it cannot make incentive allocations. So instead it pays an incentive fee to the management company. Due to the elimination of deferral fee arrangements in 2008, some investment managers have modified this by adding a mini-master structure.

In the mini-master structure, the offshore fund is the sole limited partner in a partnership (mini-master) and the general partner of the mini-master is the same as the general partner of the onshore fund or its affiliate. This allows the offshore fund to make incentive allocation to its general partner.

Of course, these are the most basic structures, and in real life, they are much more complicated.  But we thought we would start our fund blog series with the basics.

In the next blog post, we will describe the types of investors that invest into such funds, and the legal considerations involved in dealing with different types of investors. In the later blog posts, we will describe how to set up funds (again, from the legal perspective), and what laws and regulations apply to the funds and the fund managers.

This article is not legal advice, and was written for general informational purposes only.  If you have questions or comments about the article or are interested in learning more about this topic, feel free to contact its authors Arina Shulga or Kristina Subbotina.  Ms. Shulga is the co-founder of Ross & Shulga PLLC, a New York-based boutique law firm specializing in advising individual and corporate clients on aspects of corporate and securities law.

Saturday, October 6, 2018

Money Transmission and Its Implication for Cryptocurrency

From the securities and commodities industry to the financial services industry, cryptocurrencies face a variety of regulatory hurdles. The most recent hurdle comes from the Financial Crimes Enforcement Network (“FinCEN”), which may consider some of those companies, platforms, and intermediaries that utilize cryptocurrencies to be “money transmitters.”

Money transmitters are included in the broader definition of a money services business (“MSB”), which is overseen by FinCEN. A money services business could be a money transmitter, a check cashier, one who deals in foreign exchange or traveler’s checks, or one who provides a prepaid program, among others. There are two important exceptions to this definition. The first is that a bank is not an MSB. This is due to the vast regulation and several regulatory authorities that banks are already subject to. The second limitation is that those persons or institutions that are registered with, and functionally regulated or examined by, the Securities and Exchange Commission or the Commodity Futures Trading Commission are not considered an MSB. Furthermore, even though most businesses under a $1,000 do not need to register as an MSB, no such minimum threshold exists for money transmitters, which means that all money transmitters must register as an MSB. MSBs are required to register with FinCEN via Form 107, which is due within 180 days after the date on which the MSB is established.

The narrower definition of money transmitter includes those who accept currency, or funds denominated in a currency, and transmit such currency or funds by any means through a financial agency or institution or an electronic funds transfer network; or any other person engaged in the transfer of funds as a business. But to be a money transmitter, the entity must carry on money transmission as a business. Generally, the acceptance and transmission of funds as an integral part of the execution and settlement of a transaction other than the funds transmission itself (e.g., in connection with a bona fide sale of securities), will not cause a person to be a money transmitter.

Money transmitters are not only required to register as an MSB, but they are also subject to state licensure in the states where their customers are located, not where the entity is incorporated. Therefore, unlicensed foreign entities conducting money transmission within the U.S. or with U.S.-based customers may run afoul of money transmission regulation. In fact, FinCEN noted that foreign-located persons engaging in MSB activities in the United States are subject to the rules of the Bank Secrecy Act and have the same reporting and recordkeeping and other requirements as MSBs with a physical presence in the United States. This licensing scheme is often the cause of much legal and financial headache and it is often the reason many businesses shy away from being labeled a money transmitter within any state.

For those businesses that offer money transmission services, their choice is to either comply with each state’s licensing procedures or to rely on one or more of the exemptions from being a money transmitter. One such exemption would require the business to utilize another business’ money transmitter license. To do this, the exempt business would need to become an authorized delegate of the entity that holds the money transmitter license. This is similar to entering into a principal-agent relationship. In order for this to work, all payments must go through the account of the principal licensee and the product and/or service that the authorized delegate is marketing or extending out, has to tie-in to the core product and/or service of the principal licensee. This arrangement must be formed by contract between the parties.

The second exemption is the payment processor exemption. To utilize this exemption, the business would need to prove that it is receiving payment for services separate from the money transmission itself and then sending the money to a third party. For a business that makes its money on money transmission services, the payment processor exemption would not apply, but for non-transmission services businesses, this exemption is available.

The exemptions raise the issue of whether initial coin offerings (“ICO”), token generation events, tokenized private funds, or the like are running afoul of the money transmitter licensure procedures. Such an inference was made when an individual at FinCEN stated in a letter to U.S. Senator Ron Wyden (a minority-party Senator on the Intelligence Committee), “[A] developer that sells convertible virtual currency, including in the form of ICO coins or tokens, in exchange for another type of value that substitutes for currency is a money transmitter and must comply with [anti-money laundering/combatting financing terrorism] requirements that apply to this type of [money services business]. An exchange that sells ICO coins or tokens, or exchanges them for other virtual currency, fiat currency, or other value that substitutes for currency, would typically also be a money transmitter.” Furthermore, in May 2015, virtual currency exchanger Ripple Labs Inc. entered into a consent agreement with FinCEN in which Ripple consented to a $700,000 civil penalty for “acting as a money services business (MSB) and selling its virtual currency, known as XRP, without registering with FinCEN.”

The push for money transmitter licenses could cause many ICOs to rethink their business plan. Cryptocurrency issuers, platforms, and other intermediaries, unless there is an applicable exemption, they may be engaged in money transmission. Therefore, they would be required to obtain a money transmitter license from each applicable state and register with FinCEN as an MSB. This adds to the regulatory questions already surrounding ICOs, including broker-dealer and investment advisor registration.

This article is not legal advice, and was written for general informational purposes only.  If you have questions or comments about the article or are interested in learning more about this topic, feel free to contact its authors Andrew Silvia.  Mr. Silvia is an associate at Ross & Shulga PLLC, a New York-based boutique law firm specializing in advising individual and corporate clients on aspects of corporate and securities law.

Saturday, September 29, 2018

Can Startup Founders Get Paid in Equity Only?

It is a fact of life: startup founders do not get paid for their endless work day during the initial set up stage of their company.  Even though they have titles such as a CEO or a CTO, they do not see a penny until their startup gets funded and there is enough money to start the payroll.  But is it legal?

The Fair Labor Standards Act (the "FLSA") applies to most employers.  According to the FSLA, employees must be paid at least the minimum hourly wage.  Some employees must also receive overtime if they are nonexempt employees under the FLSA.  New York has its own wage and hour laws that do not quite correspond to the federal laws.

The FLSA has an executive employee exemption for certain business owners that would apply to startup founders.  According to it, the minimum wage law does not apply to those who own at least a bona fide 20% equity interest in the company and are actively involved in its management.  Good news?!

Not for everybody.  New York-based startups also need to qualify with New York's wage and hour laws, which as I mentioned, are somewhat different.  New York does not have a corresponding exemption that would apply to startup founders.  Its executive exemption (check 12 NYCRR 142-2.14) does not include minority business owners.

So, founders in New York beware:  please pay yourselves at least a minimum wage.

This article is not legal advice, and was written for general informational purposes only.  If you have questions or comments about the article or are interested in learning more about this topic, feel free to contact its author Arina Shulga.  Ms. Shulga is the co-founder of Ross & Shulga PLLC, a New York-based boutique law firm specializing in advising individual and corporate clients on aspects of corporate and securities law.

Thursday, September 27, 2018

How to Find the Right Lawyer?

This blog post is addressed to startups that are looking for legal counsel.  I was prompted to write it because of the September 24th announcement by NY Attorney General that the AG office reached an agreement with an online legal directory Avvo to reform its attorney ratings and improve disclosures for consumers.

Startup founders have a big task to handle: on one hand, they have a small (or no) budget set aside for legal services, but on the other hand, some understand that a lack of legal review can disadvantage them significantly in the future.  Many startup founders have not even talked to a lawyer before.  So, where and how do they look for a lawyer or a legal team that would be a good fit?

Legal services are mostly a referrals business.  Most matters we handle are our existing clients' new projects or referrals to new clients made by the existing ones.  So, the first thing that startup founders should do is "ask the audience," - i.e., reach out to their networks for referrals.

If this yields no results, then some ask a business accelerator or a VC for names of firms that are active in this space.  Bigger firms may not be well set up to handle small matters, but some give discounts or defer their fees.

Others turn to the Internet.  Recently, we have seen a proliferation of legal platforms or directories that allow users to select a lawyer based on their profile.  Platforms usually add their fee on top of the lawyer's rate.  All financial transactions are handled through the platform.

Being a part of a legal platform is a great way for a beginner solo practitioner with few or no clients to start their own practice.  All they have to do is create a profile and respond to client inquiries.  And here is where there is room for misleading information.

Let's take a look at Avvo, one such legal platform.  It does not vet its attorneys like some other platforms that require recommendations and in-person interviews.  Any attorney can create a profile on Avvo, and then even achieve a superb rating.  According to the NY AG, such rating could have been misleading.

The more information attorneys add to their profile, the better is their rating.  Attaining a high rating is not dissimilar to obtaining a search engine optimization of a website.  It does not necessarily correspond to the experience of that lawyer, but rather to the information that is publicly available about him / her.  As part of the agreement with the NY AG, Avvo will remove the ratings for attorneys who do not actively participate in Avvo's directory and disclose the content and limit of its ratings system to the users.  Also, Avvo agreed to ensure that all legal forms posted to its website for customers' use are first reviewed by a NY attorney with relevant experience.  Further, Avvo agreed to make other clarifying statements to their users, as well as pay a $50,000 fine.

Startup founders (and everyone else for that matter) should do a careful independent investigation of the attorney or the legal team they are about to hire, including viewing the attorney's website, searching other sources of information about the attorney online, and checking if there is any disciplinary information about the attorney with the state bar association.  It is always a good idea to ask for references.

Also, ask your attorney to provide estimates for the projects you give to them.  As a startup, you only have a limited budget for legal fees, and you want to make sure it is well spent.

This article is not legal advice, and was written for general informational purposes only.  If you have questions or comments about the article or are interested in learning more about this topic, feel free to contact its author Arina Shulga.  Ms. Shulga is the co-founder of Ross & Shulga PLLC, a New York-based boutique law firm specializing in advising individual and corporate clients on aspects of corporate and securities law.

Friday, September 14, 2018

U.S. vs Zaslavskiy - Cryptocurrency May Be a Security

I have read (and written) about Mr. Zaslavskiy and his entrepreneurial ventures, REcoin and Diamond, before.  Overall, 2.8 million tokens were sold (although none were really issued) to approximately 1,000 retail investors in two scam offerings of tokens that supposedly aimed to invest into real estate and diamonds, respectively.  The SEC order and complaint, dated September 29, 2017, can be found here.  At that time (which is only about a year ago), it was the SEC's first enforcement action against promoters of an ICO.

Now, Mr. Zaslavskiy is facing a criminal trial.  He argues that whatever he offered and sold to the public were not securities and therefore the case should be dismissed.  However, on September 11, 2018, a federal judge in the US District Court for the Eastern District of NY dismissed his motion and held that a reasonable jury could conclude that the cryptocurrency is a security, and that Mr. Zaslavskiy's case will proceed to trial.  This decision supports a long-standing position of the SEC that tokens, or digital assets, may be securities under the US federal and state laws.

Judge Dearie analyzed whether the tokens offered and sold by REcoin and Diamonds could be "investment contracts."

It is not disputed that "investment contracts" fall within the definition of security under Section 2(a)(1) of the Securities Act and Section 3(a)(10) of the Exchange Act.  Even though there is no statutory definition of what an "investment contract" is, there is the Howey test developed by the US Supreme Court in 1946.  According to the test, an investment contract is a "contract, transaction, or scheme whereby a person (i) invests his money in (ii) a common enterprise and is (iii) led to expect profits solely from the efforts of the promoter or third party."  All three prongs of the test must be met in order for there to be an investment contract.

With respect to the first prong, Judge Dearie cited cases that stated that cash was not the only form of "money" and that the investment could take form of goods and services and some other exchange of value.

With respect to the second prong, Judge Dearie said that both RE coin and Diamond could constitute a "common enterprise."  To establish this prong, there must be "commonality" among the investors, which is explained as "the tying of each individual investor's fortunes to the fortunes of other investors by the pooling of assets, usually combined with the pro-rata distribution of profits."  In re J.P. Jeanneret, 769 F. Supp. 2d at 359.  Again, if proven at trial, a reasonable jury could conclude that there was a common enterprise.

As to the third prong, the reasonable jury could conclude from the facts presented that the investors did not expect to derive any profit from their own efforts, but rather from the efforts of Mr. Zaslavskiy and his co-conspirators.  They described REcoin as "an attractive investment opportunity" that "grows in value" and has "some of the highest potential returns."  The Diamond investors were promised 10-15% per year returns.  The promotional materials stated that Mr. Zaslavskiy would use his (and his colleagues') expertise to develop the ventures, invest the funds, and generate profits.

Mr. Zaslavskiy also argued that the tokens were actually currencies, and therefore should be excluded from the definition of securities.  The Judge dismissed this argument by saying that just labeling something a currency does not mean it actually is.  Instead, one should look at the economic realities and apply the investment contract test.

Now, all that is left is to learn the outcome of the trial.  This may be the first, but not the last, time when promoters are sentenced because of conducting illegal ICOs.

This article is not legal advice, and was written for general informational purposes only.  If you have questions or comments about the article or are interested in learning more about this topic, feel free to contact its author Arina Shulga.  Ms. Shulga is the co-founder of Ross & Shulga PLLC, a New York-based boutique law firm specializing in advising individual and corporate clients on aspects of corporate and securities law.

Thursday, September 13, 2018

ICO Platforms Beware: You May Be Operating as Unregistered Broker-Dealers

On September 11, 2018, the SEC announced that TokenLot LLC, a so called "ICO Superstore," agreed to settle charges brought by the SEC for operating as an unregistered broker-dealer.  The investigation was conducted by the SEC Cyber Unit.

The ICO Superstore enabled U.S. and foreign retail investors to purchase digital tokens during ICOs and engage in secondary trading.  To be precise: (i) TokenLot advertised and sold tokens issued by others; (ii) solicited investors; (iii) processed funds; (iv) enabled secondary trading in those tokens; and (v) advertised and promoted the sale of tokens in exchange for marketing fees paid by token issuers.  In fact, they handled over 200 different digital tokens for a total of 6,100 investors, receiving $471,000 in compensation.  TokenLot made money by charging a percentage of the ICO proceeds, marketing fees, as well as trading profits.

The Securities Exchange Act of 1934 defines a broker as "any person engaged in the business of effecting transactions in securities for the accounts of others."  Section 15(a) of the Exchange Act prohibits anyone to effect any transactions in securities for others unless such person is registered as a broker or dealer.  There are, of course, exceptions to this rule for certain limited categories of people, such as intrastate broker-dealers (Section 15(a)(1) of the Exchange Act), those dealing in exempted securities only (Section 3(a)(12) of the Exchange Act), foreign broker-dealers (Rule 15a-6 of the Exchange Act), issuers, and associated persons of the issuers (Rule 3a4-1 of the Exchange Act).  Some argue that there is also a so-called "finders exemption" developed through the SEC no-action letters, but even if it exists, it is extremely narrow in scope and highly dependent on particular facts and circumstances.

According to the SEC no-action letters and a helpful Guide to Broker-Dealer Registration published on the SEC website, there are four main questions to ask in determining whether certain activity requires broker-dealer registration:

1 - Does the person receive transaction-based compensation?  This is the key factor.
2 - Does the person engage in solicitation of potential investors?  Here, solicitation is interpreted broadly.
3 - Does the person engage in negotiations, provide advice, assist investors? Does the person facilitate the transaction?
4 - Does the person have previous securities sales experience or a history of disciplinary action?

First, the determination that the tokens were "securities" for the purposes of the Securities Act and the Exchange Act is key to the analysis, since there would be no broker-dealer registration requirement if they were facilitating the sales of something that was not a security (although, as you probably know, the definition of "security" is so broad that it even included citrus groves, warehouse receipts, minks, diamonds, pay phones, and chinchillas). 

Second, activities of TokenLot and its owners provide a positive answer to the first three of the B-D questions: the TokenLot promoters marketed the ICOs and tokens to prospective investors, facilitated transactions by receiving purchase orders and investor funds, and transferring digital tokens to investors and funds to the issuer, and they received a percentage of ICO proceeds as compensation.

Although the SEC order was settled and the matter seems closed now, there are potential other charges and liabilities that could have been brought.  For example, the ICO issuers, in addition to conducting unregistered securities offerings, could face aiding and abetting violations for working with an unregistered broker-dealer).  Also, the investors may have a private right of rescission under the Exchange Act Section 29(b) which provides that any contract made in violation of any provision of the Exchange Act is void.  The investors may also have state rescission claims.

This case should be read closely by multiple online platforms that are facilitating ICOs for others.  The SEC position with respect to regulation of online equity platforms has not changed, whether they are facilitating ICOs or traditional equity private placements.

This article is not legal advice, and was written for general informational purposes only.  If you have questions or comments about the article or are interested in learning more about this topic, feel free to contact its author Arina Shulga.  Ms. Shulga is the co-founder of Ross & Shulga PLLC, a New York-based boutique law firm specializing in advising individual and corporate clients on aspects of corporate and securities law.

Wednesday, September 12, 2018

Unpaid Internships at NY For-Profit Businesses: a Wish or a Reality

Unpaid internships are a tricky proposition.  You may recall our blog post in 2013 discussing how difficult, if not impossible, it was for New York for-profit employers to offer unpaid internships.  But “the times they are a changing” because the U.S. Department of Labor (“DOL”) lessened the regulatory burden earlier this year.

On January 5, 2018, the DOL announced that it would replace its old six-part analysis with a new “primary beneficiary test” to determine whether an unpaid intern was in fact an employee and thus subject to the Fair Labor Standards Act (“FLSA”) Thanks, in part, to a case involving Fox Searchlight Pictures Inc. in the U.S. Court of Appeals for the Second Circuit, the new test considers seven factors that analyze who the primary beneficiary of the working relationship is. If the analysis of the seven factors shows the primary beneficiary of the employment relationship is the employer, then the intern is designated as an employee and the relationship is subject to minimum wage laws and overtime pay as provided in the FLSA. If, however, the relationship is for the primary benefit of the intern, then the unpaid relationship will not be subject to minimum wage and employee benefit requirements, at least under the primary beneficiary test.

Pursuant to this new primary beneficiary test, businesses that wish to offer an unpaid internship without being subject to the legal requirements involved in an employer-employee relationship should do the following: (1) refrain from making any promise of, or providing, compensation; (2) provide training similar to an educational environment including hands on training; (3) tie the internship to the intern’s formal education, including the receipt of academic credit for the internship; (4) accommodate the intern’s academic calendar and commitments; (5) limit the internship only to a period during which the intern is beneficially learning; (6) provide the intern with academically beneficial work that complements rather than displaces the work of paid employees; and (7) make clear the understanding that the intern is not entitled to a paid job at the conclusion of the internship.

As those who read our prior blog post will know, the above-mentioned factors do not include a previous requirement that the employer does not derive “immediate advantages from the activities of the trainees.” This factor was removed in the new guidance from the DOL for its lack of clear guidance. The rise of appellate court cases, such as Schumann and Benjamin, that determined the DOL’s prior test was “too rigid” and resulted in an “all-or-nothing determination”, encouraged the DOL to ease the employer’s burden and clarify the test regarding unpaid interns.

Despite its potential applicability, this primary beneficiary test only sets forth the minimum standard at the federal level, which means employers still need to consider the applicable state requirements. Unfortunately, the New York State Department of Labor (“NYDOL”) has yet to adopt similar guidance. Instead, the NYDOL maintains its pre-2018 eleven-factor test (as described in detail in our blog post). Therefore, for-profit employers in New York will still have to comply with the prior regulations, despite the new employer-friendly DOL standards.

This article is not legal advice, and was written for general informational purposes only.  If you have questions or comments about the article or are interested in learning more about this topic, feel free to contact its authors Andrew Silvia.  Mr. Silvia is an associate at Ross & Shulga PLLC, a New York-based boutique law firm specializing in advising individual and corporate clients on aspects of corporate and securities law.

SEC States that Tomahawkcoin Bounty Program was an Unregistered Security Offering

With an Order Instituting Administrative Proceedings (“Order”) dated August 14, 2018, and a corresponding press release, the SEC renewed its position that there is no such thing as a “free” offering of securities. While we have previously cautioned here that airdrops and other token giveaways should be structured in a manner compliant with the Securities Act, this enforcement action against Tomahawk Exploration LLC (“Tomahawk”) marks the first public action the SEC has taken against issuers distributing tokens to participants in a company's bounty program.

If you wonder what a typical bounty program is, here is a helpful blog post that summarizes ICO bounty programs.  ICO bounty programs have become ubiquitous in the ICO deals.  Terms vary, but typically participants receive tokens in exchange for reviewing the code, and marketing and promoting the ICO.

The enforcement action against Tomahawk lays a clear groundwork that the SEC may apply when investigating bounty programs in the future. From July through September 2017, Tomahawk, an oil and gas exploration company, and its founder, David Laurance (who had previously served a prison sentence for securities-related fraud), offered and attempted to sell digital assets in the form of “Tomahawkcoins” or "TOMs" in an ICO. They sought to raise $5 million to fund oil drilling in California. Tomahawk’s website and white paper touted the tokens’ potential for substantial long-term profits based on fraudulent estimations of Tomahawk’s anticipated oil production. Promotional materials also represented that investors could trade their tokens for potential profits on a token trading platform, and that they would could convert their tokens into Tomahawk equity at a 1:1 ratio on a future date.

The SEC noted that, although Tomahawk failed to raise money through the ICO, Tomahawk did issue TOMs as part of a “Bounty Program” in exchange for online promotional and marketing services. Tomahawk featured the Bounty Program prominently on the ICO website, offering TOMs in exchange for actions such as (i) listing of TOMs on token trading platforms, (ii) promoting TOMs on blogs and social networking websites, and (iii) creating promotional materials for the offering. Under this program, Tomahawk issued more than 80,000 TOMs to approximately 40 wallet holders on a decentralized platform.  In exchange, Tomahawk received online promotions that targeted potential investors to Tomahawk’s offering materials.

The SEC concluded that the TOMs constituted securities as both “investment contracts” (acquired by investors with expectation of future increase in value) and because the tokens were convertible into equity securities, thereby representing a right to an equity share of the company. Additionally, the SEC concluded that TOMs were "penny stock" because they did not meet any of the exceptions from the definition of "penny stock" found in Section 3(a)(51) of the Exchange Act and Rule 3a51-1 thereunder.  This is the first time that the SEC has concluded that tokens could be "penny stock" (which is interesting given that no TOMs were actually sold in the ICO and none ever traded on an exchange).  Penny stock carries additional risks, such as difficulty to accurately price the stock due to infrequent trading.  Typically, penny stock investments are speculative in nature, and therefore are regulated.

Further, the SEC determined that distributing the coins pursuant to the Bounty Program was a sale under Section 2(a)(3) of the Securities Act despite the lack of monetary consideration.  It is a long-standing SEC position that goes back to the 1999 SEC release that “gifting” securities constitutes a “sale” when the donor receives a “real benefit.” The SEC therefore determined that Tomahawk had "sold" the tokens in exchange for value in the form of online marketing promotion and increased liquidity in the securities of the company.

Although the situation with Tomahawk was a clearly fraudulent 21st century reinterpretation of an oil and gas scheme, issuers conducting bounty programs should heed the warning and ask themselves if they are “giving” away tokens in exchange for “value.”  If the SEC Order is taken at face-value, almost any action that has a benefit for an issuer, no more how marginal, may be construed as “value.”  Careful issuers should make sure that their bounty programs are compliant with an exemption from the registration requirements of the Securities Act or risk the SEC scrutiny.

This article is not legal advice, and was written for general informational purposes only.  If you have questions or comments about the article or are interested in learning more about this topic, feel free to contact its authors Ignacio Celis-Aguirre and Arina Shulga.  Ms. Shulga is the co-founder of Ross & Shulga PLLC, a New York-based boutique law firm specializing in advising individual and corporate clients on aspects of corporate and securities law.

Friday, September 7, 2018

How to spot a fake private offering?

I recently came across an SEC Investor Alert through another blog posting, which I decided to highlight on my blog as well because of its increased relevance and importance in today's investment environment. I am referring to the Investor Alert: 10 Red Flags That an Unregistered Offering May Be a Scam from August 4, 2014.

This guidance has become particularly important because of the adoption of Rule 506(c) that allows private placements to be conducted using general solicitation and advertisement.  Although all purchasers in such offerings must be "accredited investors," information about such offerings gets widely disseminated and reaches the eyes of the unsophisticated and nonaccredited investors through websites and social media.

Below is a list of some of the red flags discussed by the SEC:

1.  Claims of high returns with little or no risk.  Every private placement memorandum should have a section on risk factors relating to that particular offering.  If you don't find one, assume two things: (i) this PPM is incomplete, and (ii) the risks, even though unstated, still exist (and in abundance).

2.  Unregistered investment professionals.  Always check the bios of the management team, as well as the profiles of the people promoting the offering.  The promoters must always be registered as investment advisers and/or broker-dealers with the SEC.  You can check the promoters' records on the Investment Adviser Public Disclosure website or FINRA's BrokerCheck.  A missing registration is a red flag.  I have written extensively about using unregistered broker-dealers in the past.

3.  Problems with sales documents.  Definitely avoid handshake deals.  Avoid signing agreements that you do not understand.  Read the PPM in its entirely to spot any inconsistencies, mistakes, and typos.  All factual information should have references, and no promises should be made.  When you are thinking of investing, do an Internet search and a search of the company's home state Department of State website to determine whether such business actually exists.

4.  Beware of offerings that are extended to nonaccredited investors.  Most private placement offerings are only available to accredited investors.  Those that are not are probably done in circumvention of applicable federal and state securities laws.  There are, of course, exceptions.  Rule 506(b) private placement can include up to 35 nonaccredited but sophisticated investors, and Title III crowdfunding offerings conducted through registered portals can be extended to an unlimited number of nonaccredited investors.

5.  Where are the lawyers?  A private placement offering is typically done with the assistance of a law firm.  Check whether this is the case.  If not, - participation in such offering is not recommended.  If yes, - read the firm's profile.  Are the involved attorneys experts in the area of securities laws?

These (and other) red flags have become increasingly important in light of numerous initial coin offerings offered through the Internet to retail investors.  Recently, to set an example, the SEC launched a bogus offering of HoweyCoins to illustrate to the investors what a scam ICO could look like. 

However, regardless of the SEC guidances and illustrations, there are many investors who have recently become victims of online investment fraud scams.  Thus, it is important to continuously remind investors how to recognize scam offerings and to avoid them.

This article is not legal advice, and was written for general informational purposes only.  If you have questions or comments about the article or are interested in learning more about this topic, feel free to contact its author Arina Shulga.  Ms. Shulga is the co-founder of Ross & Shulga PLLC, a New York-based boutique law firm specializing in advising individual and corporate clients on aspects of corporate and securities law.

Saturday, July 14, 2018

Not All ICOs are Securities Offerings

William Hinman, Director for the Division of Corporation Finance of the U.S. Securities and Exchange Commission (the “SEC”), delivered a speech on June 14, 2018, that is helpful in defining the U.S. regulatory framework surrounding digital assets. For promoters, investors, and other market participants in the blockchain and cryptocurrency space, Director Hinman's speech comes as a breath of fresh air after the SEC Chairman, Jay Clayton, stated that “every ICO I’ve seen is a security” just months ago. For others, like the legal practitioners active in the crypto assets field, this speech may be seen as creating more questions than answers.

Director Hinman directly addressed the question that has already been hinted at by other SEC (and the CFTC officials): whether a digital asset that was originally offered as a security be later sold as something other than a security.  In particular, everyone had wondered whether the current sales and offers of Ether, the underlying token powering the Ethereum blockchain, were sales and offers of securities. We can all agree that Ethereum’s initial coin offering would undoubtedly be considered as a securities offering in the eyes of the SEC. Considering that Ethereum is one of the most popular platforms for tokens to run on, this is an essential issue for many in the space.

Acknowledging the possibility that a digital asset that was initially offered as a security can later be sold as a non-security, Director Hinman gave examples that would tip the scale in favor of a digital asset being a non-security. Based on Director Hinman’s examples, if the enterprise that is being invested in has become decentralized, or if the digital asset is being sold only to be used to make purchases “through the network on which it was created,” it is likely that the digital asset will not be considered a security. As to Ether, Director Hinman stated: “…the present state of Ether, the Ethereum network, and its decentralized structure, current offers, and sales of Ether are not securities transactions.”

So, it seems like the “once a security, always a security” may no longer be true in certain circumstances, once you have a “decentralized” network where the digital asset is used to make purchases on, or obtain access to, the network. It is unclear, however, how one determines the precise point in time when the security metamorphoses into just a token, and how one "transitions" out of the securities law framework.

A more general issue, of whether all ICOs constitute securities offerings, was answered with a resounding NO. However, Director Hinman made it clear that the label given to a particular digital asset, such as a “utility token,” is inconsequential as to whether it is a security or not. “Whether a transaction in a coin or token on the secondary market amounts to an offer or sale of a security requires a careful and fact-sensitive legal analysis,” Director Hinman stated.

While Director Hinman acknowledges that digital assets are “simply code,” and not inherently securities, he looks towards Gary Plastic Packaging Corp. v. Merrill Lynch, Pierce, Fenner & Smith, Inc., 756 F.2d 230 (2d Cir. 1985) that says that “an instrument can be part of an investment contract that is a security,” regardless of the nature of the instrument itself. There are cases where even whiskey warehouse receipts and chinchillas were deemed to be “securities.” Consequently, we must look closely at the nature of the digital asset and the parties that are involved in the transaction.

Director Hinman reiterated the SEC's determination to apply the “Howey Test,” the current test for determining whether an “investment contract” constitutes a security set forth in SEC v. W.J. Howey Co., 328 U.S. 293 (1946), to each offering of digital assets. For the “Howey Test” to be satisfied (which means that the instrument is a security), there must be: 1) an investment of money; 2) in a common enterprise; 3) with an expectation of profit, and 4) the profit is derived from the efforts of others.

The application of the Howey Test to any particular offering of digital assets requires analysis of each particular set of facts and circumstances. No two offerings are alike, and the promoters and their counsel should carefully assess each offering to determine whether the U.S. federal securities laws apply. It is possible to structure a digital asset offering more or less like a securities offering, and Director Hinman offered a list of possible features and questions that could influence the outcome:

1. Is token creation commensurate with meeting the needs of users or, rather, with feeding speculation?

2. Are independent actors setting the price or is the promoter supporting the secondary market for the asset or otherwise influencing trading?

3. Is it clear that the primary motivation for purchasing the digital asset is for personal use or consumption, as compared to investment? Have purchasers made representations as to their consumptive, as opposed to their investment, intent? Are the tokens available in increments that correlate with a consumptive versus investment intent?

4. Are the tokens distributed in ways to meet users’ needs? For example, can the tokens be held or transferred only in amounts that correspond to a purchaser’s expected use? Are there built-in incentives that compel using the tokens promptly on the network, such as having the tokens degrade in value over time, or can the tokens be held for extended periods for investment?

5. Is the asset marketed and distributed to potential users or the general public?

6. Are the assets dispersed across a diverse user base or concentrated in the hands of a few that can exert influence over the application?

7. Is the application fully functioning or in early stages of development?

Overall, Director Hinman’s statements brought much needed clarity and guidance to the issues surrounding the offering and sale of digital assets; however, they do reflect his own views. It is unclear whether legal practitioners may rely on these statements, and if yes, then to what extent.  It is helpful, though, that the SEC is now open to receiving no-action letter requests, a response to which would provide an official SEC decision.  Given how policies and interpretations tend to change over time, it would be particularly helpful for those legal practitioners who are advising ICO issuers to have clear rules and bright-line tests to apply rather than statements by officials from different agencies that sometimes express conflicting views.

This article is not legal advice, and was written for general informational purposes only.  If you have questions or comments about the article or are interested in learning more about this topic, feel free to contact its authors, Brad Klingener and Arina Shulga.  Mr. Klingener is a second-year law school student at Brooklyn Law School and is a summer intern at Ross & Shulga PLLC.  Ms. Shulga is the co-founder of Ross & Shulga PLLC, a New York-based boutique law firm specializing in advising individual and corporate clients on aspects of corporate and securities law.

Should All Accredited Investors Be Wealthy?

            Instead of undergoing the expensive process of conducting a public offering of securities, companies have continually relied upon Regulation D to conduct private placements of securities. Among other requirements of Regulation D, companies are limited to selling their securities only to the “accredited investors” (with some exceptions).

            Rule 501 of Regulation D defines an accredited investor (as it pertains to individuals) as any one of the following: (i) a director, executive officer, or general partner of the issuer of the securities being offered; (ii) a natural person whose individual net worth, or joint net worth with that person's spouse, exceeds $1,000,000 (excluding the value of the primary residence); or (iii) a natural person who had an individual income in excess of $200,000 in each of the two most recent years or joint income with that person's spouse in excess of $300,000 in each of those years and has a reasonable expectation of reaching the same income level in the current year.

Accredited investors are presumed to have a higher level of financial sophistication and financial wealth that enables them to conduct proper due diligence and withstand a total loss of their investment. Also, it is presumed that, if accredited investors are lacking financial savvy, they can afford to hire financial advisers.  Indeed, often the most relevant parts of the definition of an accredited investor are in determining the investor’s net worth or annual individual or joint income. But the idea that wealth alone is some measure of financial sophistication is misleading.

Consider a successful doctor or a wealthy actor. It would be reasonable to assume that these individuals do not necessarily possess the financial sophistication needed to make smart financial investments.  On the other side, consider financial analysts or investment advisers who, while working daily with securities and investments, do not meet the “accredited investor” minimums.  Yet, it will be the doctors and the actors who, in our hypothetical, will be accredited investors.

There have been suggestions for reform. Pursuant to the Dodd-Frank Wall Street Reform and Consumer Protection Act, the U.S. Securities and Exchange Commission (“SEC”) is required to review the accredited investor definition as it relates to natural persons every four years to determine whether the definition should be modified or adjusted. The last review occurred in December 2015, which means we are still one year away from the second report. But that has not stopped the U.S. House of Representatives from proposing legislation to expand the definition in December 2016, and SEC Chairman Michael Piwowar from speaking on the need for reform of the definition in February 2017. The most common suggestion is to expand the definition of accredited investor to include individuals with a securities license and those who have passed a securities examination.

In our opinion, expanding the definition of accredited investor would increase the pool of potential investors and help facilitate the flow of capital into the startup economy.  It would lead to an increase in jobs and the growth of the U.S. private sector.  On the other hand, the need to protect investors is paramount, and the criteria for accredited investors need to remain simple and straight-forward to apply.  Given these considerations, it would be desirable to expand the definition to include non-financial criteria, such as knowledge in the securities and investment areas, as evidenced by the passing of Series 7, Series 65, 82 and CFA examinations and equivalents.  The definition should also be expanded to include individuals who work in finance-related fields and who obtain a letter or certification regarding their financial acumen from their direct superiors.  However, the amount of investment by such individuals should be limited to no more than 25% of their annual income. 

All we can do is wait another year until the next review of the accredited investor definition in the hope that the definition will include those who have the qualifications needed to knowingly participate in the investments in the early-stage companies.

This article is not legal advice, and was written for general informational purposes only.  If you have questions or comments about the article or are interested in learning more about this topic, feel free to contact its authors, Andrew Silvia and Arina Shulga.  Ms. Shulga is the co-founder of Ross & Shulga PLLC, a New York-based boutique law firm specializing in advising individual and corporate clients on aspects of corporate and securities law.