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.