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.