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.

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