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 has wondered whether the current sales and offers of Ether, the underlying token powering the Ethereum blockchain, are sales and offers of securities. We can all agree that Ethereum’s iinitial coin offering would undoubtedly be considered 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 a 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 a 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.

Thursday, May 31, 2018

Section 3(c)(1) of the Investment Company Act now allows small VC funds to have up to 250 investors

Those of you who work with investment funds will agree with me that this news is worth a separate blog posting.  The Economic Growth, Regulatory Relief and Consumer Protection Act (the "Act") became law on May 24th, 2018.  The Act significantly amends the Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010.  There are many many changes to discuss, but my blog post will focus on just one change that is of importance to our private fund clients: venture capital funds with less than $10 million in capital commitments can have up to 250 investors and still rely on the exemption from the definition of "investment company" found in Section 3(c)(1) of the Investment Company Act.

Just to be clear, the old version of Section 3(c)(1) said that "any issuer whose outstanding securities are beneficially owned by not more than one hundred persons and which is not making and does not presently propose to make a public offering of securities" would not be an "investment company" under the Investment Company Act.

Although simple on its face, the exemption actually contains a quite complicated method of calculating beneficial owners of securities, requiring to "look through" the record ownership of each potential purchaser.  Also, all investors had (and still have) to be "accredited investors" under the Securities Act.

The new Section 3(c)(1) adds "(or, in the case of a qualifying venture capital fund, 250 persons)" after the words "one hundred persons" and at the end the following: "The term "qualifying venture capital fund" means a venture capital fund that has not more than $10,000,000 in aggregate capital contributions and uncalled committed capital ...".

This is an important change.  For years,  in order to be exempt from the provisions of the Investment Company Act, private funds relied on one of two available exemptions: Section 3(c)(1) that allowed only up to 100 "accredited investors" or Section 3(c)(7) that allows for unlimited number of "qualified purchasers", which is a much higher standard than "accredited investors".  Under Section 2(a)(51) of the Investment Company Act, a "qualified purchaser" is, among others, a person with at least $5 million in investments, a company with at least $5 million in investments owned by close family members, or a company that has at least $25 million of investments.  Given that the "qualified purchaser" is a much higher standard to meet, the private funds were typically constrained by the 100 "accredited investors" limitation in Section 3(c)(1).

The increased limit allows funds to have more investors, which means that the venture capital funds can now lower the minimum subscription amounts.  This would attract more investors, and therefore facilitate the capital raising process. 

However, note that this change applies only to venture capital funds, which is not a defined term in the Investment Company Act.  However, a definition of a "venture capital fund" can be found in Rule 203(l)-1 promulgated by the SEC under the Investment Advisers Act.  Is this the definition that should be used for the purposes of Section 3(c)(1) of the Investment Company Act?  Does it mean that hedge funds that are private funds relying on the 3(c)(1) exemption are still limited to 100 investors?

Although some unanswered questions remain, I generally welcome this change because it aims to facilitate capital raising on the part of the VC funds, and consequently, by start-ups.

This article is not a 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.  She is also a member of Wall Street Blockchain Alliance.

Monday, May 28, 2018

There are No Such Things as "Free" Airdrops

Recently, as the digital asset industry is coming to terms with the increased regulatory scrutiny of the initial coin offerings, airdropping of tokens to US persons has gained popularity.  The main appeal, apart from the technological ability to widespread the tokens in no time, is the argument that since the tokens are "airdropped" for free, there is no sale of "securities" taking place, and therefore, there is no need to comply with the US securities laws.

Well, I am sorry to disappoint you, but this is a wrong argument to make.  The US securities attorneys will point you to the 1999 SEC release that came out as a result of the so-called "free stock" offerings over the Internet in the late 1990s, well before such concepts of "airdrops" and "digital assets" became household words.  The SEC then brought four enforcement actions against promoters and companies who offered and distributed free stock because they failed to properly register such offerings or qualify them for applicable exemptions.

The SEC Enforcement Director said "Free stock is really a misnomer... . While cash did not change hands, the companies that issued the stock received valuable benefits. Under these circumstances, the securities laws entitle investors to full and fair disclosure ... ."

The release then explains: "In each of the four cases, the investors were required to sign up with the issuers' web sites and disclose valuable personal information in order to obtain shares. Free stock recipients were also offered extra shares, in some cases, for soliciting additional investors or, in other cases, for linking their own websites to those of an issuer or purchasing services offered through an issuer. Through these techniques, issuers received value by spawning a fledgling public market for their shares, increasing their business, creating publicity, increasing traffic to their websites, and, in two cases, generating possible interest in projected public offerings."

As you can see, there is really no such thing as "free" distribution of securities, including digital assets. Even if money does not change hands, issuers that are conducting airdrops are receiving something else that is perhaps more valuable to them at the time: marketing, publicity, visibility, customer base.

Therefore, issuers that are conducting similar free token giveaways should ask themselves a question whether they expect to derive ANY benefits or value from doing this? Would they be doing the airdrops at all if no benefit or value was expected? If the answer is "yes, they expect to receive certain value," then these tokens should be treated as "securities" and be available (even if free of charge) only to verified accredited investors or in a way that is compliant with another available exemption from the registration requirements of the Securities Act.

This article is not a 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.  She is also a member of Wall Street Blockchain Alliance.

Friday, February 16, 2018

State Securities Regulators Crack Down on Crypto

In recent months, the Securities and Exchange Commission (the “SEC”) and the Commodity Futures Trading Commission (the “CFTC”) have issued warnings to those involved in cryptocurrencies, initial coin offerings, and token generation events. Following the lead of the federal regulators, the state securities regulators have halted certain offerings of cryptocurrency and initial coin offerings citing fraudulent activity as chief among their concerns.

On January 24, 2018, the Texas State Securities Board (the “TSSB”) prevented a “global cryptocurrency” from being offered to Texas residents in what the TSSB considered to be an offering of unregistered securities. Note that R2B Coin was a resident of Hong Kong, and its manager was an entity domiciled in Hong Kong and Dubai. R2B Coin promoters claimed that their coin would become one of the leading, most stable and most usable cryptocurrencies in the world. The Texas residents were solicited by being invited to participate in the USA Conference Calls and through the defendants’ website. The TSSB found that the R2B Coins were not registered or qualified in Texas and the defendant was not registered as a dealer with the SEC. Further, the TSSB found that the defendant engaged in fraud in connection with the offer and made misleading and deceptive statements. It is interesting to note that there is no direct connection between Texas and the defendants, other than the website offering accessible by everyone and the invitation to join one of the USA Conference Calls.

On February 9, 2018, the Attorney General for the State of New Jersey issued a cease and desist order against BitsTrade, an investment pool guaranteeing profits. The Attorney General found that the investment in the investment pool was a security and that BitsTrade failed to register itself as a broker-dealer under the New Jersey Uniform Securities Laws. Again, BitsTrade had no connection to New Jersey, other than the fact that BitsTrade had a website accessible by anyone. It is unclear whether any New Jersey residents invested into BitsTrade. Regardless of the connection, the NJ Attorney General concluded that the BitsTrade Investment was an unregistered security; BitsTrade was not registered in NJ as a broker-dealer; and it engaged in fraud by omitting to provide all of the material information regarding the company and the offering to the prospective investors.

Finally, a class action lawsuit was brought to the U.S. District Court of the Middle District of Florida against BitConnect, the crypto-lending and exchange platform that recently shut down as a result of what many believe to be a failed ponzi scheme. This lawsuit makes it BitConnect’s fifth class-action lawsuit in the U.S and the third in the State of Florida. 

All of the aforementioned cases come on the heels of the Massachusetts Securities Division ordering Caviar to cease operations and the TSSB ordering AriseBank to cease operations.

State securities regulators are becoming more active and it is causing concern for an industry trying to fit the square peg of ICOs into the round hole of state and federal regulations. But the recent actions taken by state securities regulators shed light on areas that future ICO issuers should be aware of. Aside from the obvious recommendation to be accurate and avoid materially misleading statements, the following guidance has also been highlighted in several of the aforementioned cases:
  • Conduct a “blue sky laws” analysis of the ICO and make notice filings or other relevant applications in the states where the company is headquartered and resident states of all investors (note that New York requires pre-filing);
  • Disclose the true identity and qualifications of the issuer’s principals;
  • Provide full and accurate disclosure about the issuer and the offering. Avoid grandiose claims or determinative forward-looking statements of investment growth, such as using the phrase “guaranteed” or “outstanding returns”;
  • Avoid using adjectives that subjectively tout the ICO, including words like “best”; and
  • Avoid inadvertently acting as a broker-dealer and transacting in securities without being properly licensed.
Most importantly, every ICO issuer should remember to comply not only with the federal securities laws, but also with the state “blue sky” securities laws.

This article is not a 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.

Monday, February 12, 2018

Overview of the SEC Regulation of Virtual Currency: Do Utility Tokens Still Exist?

In this post, I would like to analyze the trend in the regulation (including guidance) by the Securities and Exchange Commission (the "SEC") of the virtual currencies offerings, often referred to as ICOs (initial coin offerings) or TGEs (token generation events).  Please note that all opinions expressed herein are my own.

The first major SEC pronouncement regarding digital assets was the investigative report issued by the SEC on July 25, 2017 "concluding DAO Tokens, a digital asset, were securities."  I am sure that by now you know the details of this report.  There are, however, two thing I would like to note.  First, the SEC determined not to pursue an enforcement action in this matter, and instead issued an investigative report.  Second, the general impression from the report was that some, but not all, of the offered tokens out there were "securities" under the US federal laws, and that all depended on the "facts and circumstances" of that particular set of tokens.  The DAO report described what a "security" token could look like.  However, it left undefined the boundaries around the "utility" token.  In my opinion, this resulted in much speculation and agonizing in the legal profession regarding the precise divide between the "security" and "utility" tokens, something that now (in retrospect) seems like an unnecessary task.   Some legal practitioners adopted a conservative attitude trying to fit the tokens of their clients within the tests provided by the 1946 SEC v. W. J. Howey Co. case, while others tried to redefine the functionalities of the tokens to fit them within the "utility" realm.

Regardless of the interpretations, several things became clear to the legal practitioners and the ICO world: (i) traditional tests used to determine what are securities applied regardless of whether the issuing entity was a traditional company or a decentralized autonomous organization and whether the securities were purchased with fiat or virtual currency; (ii) the DAO token holders could immediately re-sell their tokens on secondary platforms; (iii) the DAO token holders held certain voting rights, although they were essentially meaningless given the power of the DAO Curators; and (iv) the DAO token holders expected to earn profits by investing into promising projects.  Knowing these features, applying the Howey test became an important exercise in determining whether any particular tokens were "securities" under the US laws.

The next step came two months later, at the very end of September 2017, when the SEC filed charges against Maksim Zaslavsky and the two ICOs supposedly backed by investments into real estate and diamonds.  According to the SEC complaint, investors into REcoin Group Foundation and DRC World (aka Diamond Reserve Club) expected sizable returns from the companies' operations but in fact neither company had any operations.  In addition to charges for fraud, the SEC's charges included selling unregistered securities.  The numerous fraudulent representations made by the principal raised the investors' expectations to make a profit from their investments.  There was a clear and predominant fraudulent component to those ICOs.

Then, on December 4th, the recently created SEC Cyber Unit filed an emergency asset freeze to stop the ICO fraud allegedly perpetrated by Dominic Lacroix and his company PlexCorps.  Mr. Lacroix marketed and sold PlaxCoins claiming that these investments would "yield a 1,354 percent profit in less than 29 days."  Once again, even though the defendants were charged with violating the anti-fraud provisions as well as the registration provisions, the focus of the SEC seemed to be on the ICO scams.

Until December 11th, 2017, the "utility" vs "security" debate had remained largely the same: lots of speculation and uncertainty.  Then, on December 11th, came the SEC order against Munchee, Inc., a California-based company that was conducting an ICO of its tokens that had a definite utility component.  The one thing that was different about this ICO was that it did not involve fraud.  The main focus of the SEC cease-and-desist order was on the ubiquitous question of whether or not those tokens were "securities."  This order put many legal practitioners on guard by refining the previous guidance issued in the DAO report on the nature of the tokens.

Munchee was raising funds to improve their restaurant review app, hoping to create an ecosystem where users would receive tokens for writing food reviews and would then buy and sell goods and services using the tokens.  Throughout the offering, the company emphasized that investors could expect an increase in value of the tokens, and that it would take steps to create and support a secondary market in the tokens even before the ecosystem was built.

The SEC determined that MUN tokens were "investment contracts" under the Howey test because the investors had a reasonable expectation of obtaining future profit based tokens' appreciation in value due to the Munchee team's efforts to revise the app and create the ecosystem.  The SEC also noted that "even if MUN tokens had a practical use at the time of the offering, it would not preclude the token from being a security."  This meant that even tokens with utility aspects could be deemed to be "securities" under the US laws.

On January 30th, 2018, the SEC halted another fraudulent ICO that aimed to get investors to fund "the world's first decentralized bank" called AriseBank.  According to the SEC complaint, AriseBank lied to the public by saying that it purchased an FDIC-insured bank that offered its customers FDIC-insured accounts and the ability to get a VISA credit card linked to cryptocurrencies.  In addition to the 10b-5 claims, the SEC claimed violation of Section 5(a) (failure to register securities).

So, we come to the February 6th testimony by Jay Clayton, the Chairman of the SEC before the Senate's Committee on Banking, Housing, and Urban Affairs.  This speech confirms what most experienced legal practitioners suspected from the beginning, - that most ICOs are offers and sales of securities.  Mr. Clayton stated: "When investors are offered and sold securities - which to date ICOs have largely been - they are entitled to the benefits of state and federal securities laws and sellers and other market participants must follow these laws."  Mr. Clayton also stated that "... simply calling something a currency" or a currency-based product does not mean that it is not a security."  Further, "[m]erely calling a token a "utility" token or structuring it to provide some utility does not prevent the token from being a security."

Mr. Clayton also mentioned the need for increased federal regulation of cryptocurrency trading platforms and cautioned that platforms that effect or facilitate transactions in virtual currencies may be operating as unregistered broker-dealers in violation of the Securities Exchange Act of 1934.

In conclusion, the last six or so months have shaped the US policy towards regulation of initial coin offerings.  Through the pronouncements, guidance, enforcement actions, and cease-and-desist orders, the SEC has shown readiness to combat fraud and to regulate most, if not all, ICOs as "securities."  Going forward, any client wanting to structure their token offering directed at US investors as "utility token" offering outside of the realm of the US securities laws, would be ill advised to do so.     

This article is not a 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, February 11, 2018

Recent CFTC enforcement actions related to digital assets

The recent CFTC enforcement actions have highlighted the fact that the US regulators are paying increased attention to the conduct of ICOs and the trading of digital assets.

All three cases involve fraud.  The January 16, 2018 enforcement action charged My Big Coin Pay, Inc. and its principals with fraud and misappropriation of  over $6 million from customers by transferring customer funds into personal bank accounts and using those funds for personal expenses and the purchase of luxury goods.  The action states that for four years the defendants misrepresented to customers that their virtual currency known as My Big Coin ("MBC") was actively traded on several currency exchanges, which in fact it was not; that MBC was backed by gold, which was not true; and that MBC partnered with MasterCard with the promise that MBC could be used anywhere MasterCard was accepted, which was also not true.  (The CFTC release is found here).

The CFTC filed its second civil enforcement action on January 18, 2018 against Dillon Michael Dean of Colorado and his company The Entrepreneurs Headquarter Limited, a UK-registered company.  The CFTC complaint charges the defendants with soliciting Bitcoins from the public, misrepresenting that a portion of the funds would be used to invest into products such as binary options, making Ponzi-style payments to the participants from other participants' funds, and failing to register as a commodity pool operator with the CFTC.

Also, on the same day, the CFTC charged Patrick McDonnell and his company CabbageTech, Corp. d/b/a Coin Drop Markets with fraud and misappropriation in connection with purchases and trading of Bitcoin and Litecoin.  The defendants solicited customers to send them money or virtual currencies in exchange for virtual currency trading advice that was never delivered.

The first question that comes to mind is why is it the CFTC that is filing these enforcement actions, and not the SEC?  After all, we have all been preoccupied with the question of whether digital tokens are securities under the US securities laws, and the regulation of securities offerings is the realm of the SEC.  The second question is whether investment managers of crypto funds (investment funds that pool money to invest into digital assets) have to register with the CFTC as commodity pool operators (CPOs).

According to the recent SEC pronouncements, more and more tokens are going to be deemed to be securities rather than utility tokens or currencies, especially while the platform on which they would function has not yet been built.  Those other tokens that are not securities may be utility tokens or currencies, which makes them "commodities" falling under the regulation by the CFTC. 

In its 2015 Order in to the Matter of CoinFlip, Inc., the CFTC said:

"Section 1a(9) of the Act defines "commodity" to include, among other things, "all services, rights, and interests in which contracts for future delivery are  presently or in the future dealt in." 7 U.S.C. § 1a(9). The definition of a  "commodity" is broad. See, e.g., Board ofTrade ofCity ofChicago v. SEC, 677  F.  2d 1137, 1142 (7th Cir. 1982). Bitcoin and other virtual currencies are  encompassed in the definition and properly defined as commodities."

Since commodity-based derivative contracts are within the CFTC regulation, including registration, reporting and other requirements, the CFTC charged CoinFlip with unlawfully offering commodity options without being properly registered with the CFTC.

In October 2017, the LabCFTC issued a Primer on Virtual Currencies, in which it considered possible cases where the virtual currency is deemed to be a commodity.  The report confirmed that Bitcoin and other virtual currencies are commodities.  The CFTC has oversight of derivatives, futures and options contracts and that "the CFTC's jurisdiction is implicated when a virtual currency is used in a derivatives contract, or if there is fraud or manipulation involving a virtual currency traded in interstate commerce."   The report also stated that there is no inconsistency between the regulation by the SEC and the CFTC because "virtual tokens may be commodities or derivatives contracts depending on the particular facts and circumstances."

Therefore, regulation and enforcement actions by both the SEC and the CFTC are appropriate in connection with fraudulent practices on the ICO market.  It has been argued with respect to the overlapping of the CFTC and the SEC jurisdictions, that the CFTC may be better positioned to deal with fraud in virtual currency markets because its Rule 180.1 (the equivalent of the SEC Rule 10b-5) has a broader reach.  It extends to any "manipulative device, scheme, or artifice to defraud" that has a relationship to a commodity in interstate commerce, whereas Rule 10b-5 applies only to the actual transaction involving the purchase or sale of a security.

Now, let's consider our second question.  The CFTC defines a commodity pool as "an investment trust, syndicate, or similar form of enterprise operated for the purpose of trading commodity futures or option contracts. Typically thought of as an enterprise engaged in the business of investing the collective or “pooled” funds of multiple participants in trading commodity futures or options, where participants share in profits and losses on a pro rata basis."  Accordingly, those crypto funds that invest their funds into derivative contracts based on virtual currencies may well be deemed to be commodity pools, and therefore, their managers would need to register with the CFTC as commodity pool operators.

One of the charges brought by the CFTC in the January 18th enforcement action against Dean and The Entrepreneurs Headquarters Limited was Dean's failure to register as a CPO.

In conclusion, it is likely that we will see more CFTC actions against participants in the virtual currency marketplace, as well as joint SEC and CFTC enforcement efforts. 

This article is not a 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.