SEC Provides Enforcement Driven Guidance On Digital Asset Issuances And Trading
On November 16, 2018, the SEC settled two actions involving cryptocurrency offerings which settlement requires the registration of the digital assets. On the same day, the SEC issued a public statement stating, “[T]hese two matters demonstrate that there is a path to compliance with the federal securities laws going forward, even where issuers have conducted an illegal unregistered offering of digital asset securities.”
The two settled actions, CarrierEQ Inc., known as Airfox and Paragon Coin Inc., both involved an unregistered issuance of a cryptocurrency. In its statement the SEC highlighted three other recent settled actions involving digital assets and, in particular, the actions involving Crypto Asset Management, TokenLot and EtherDelta. The three additional cases involved investment vehicles investing in digital assets and the providing of investment advice, and secondary market trading of digital asset securities.
The SEC has developed a consistent mantra declaring both support for technological innovation while emphasizing the requirement to “adhere to [our] well-established and well-functioning federal securities law framework…” However, as Commissioner Hester Peirce has pointed out in her speeches, the current federal securities law may not be the best framework for the regulation of digital asset securities and their secondary trading. Although the overall purpose and structure of the Securities Act of 1933 (“Securities Act”) and its implementing rules, including the idea that the offer and sale of securities must either be registered or issued under an available exemption, and that investors are entitled to disclosure, may be appropriate, the granular requirements under the Act need to be updated to encompass new technology including blockchain and digital assets. Likewise, and maybe even more so, the broker-dealer, ATS and national exchange registration requirements, and the reporting requirement of issuers found in the Securities Exchange Act of 1934 (“Exchange Act”) and its implementing rules, need to be reviewed and updated.
Airfox and Paragon Coin Inc. – Offers and Sales of Digital Asset Securities
The SEC has brought many actions related to the offers and sales of digital assets – some before, and many after, the issuance of its Section 21(a) Report related to the offer and sale of tokens by the DAO. The Section 21(a) Report clearly laid out that a determination of whether a digital asset is a security requires an analysis using the Howey test as set out in the U.S. Supreme Court case SEC v. W. J. Howey Co. In various speeches and public statements following that Report, SEC officials, including Chair Jay Clayton, expressed their views that pretty well all ICOs to date involved the offer and sale of a security and, unfortunately, many had not complied with the federal securities laws. A slew of enforcement proceedings followed and a shift in the ICO craze to a more compliant securities token offering (STO) resulted.
However, to date, STOs have relied on registration exemptions, such as Regulation D, in their offerings rather than registration under the Securities Act. When registering an issuance under the Securities Act, an issuer must comply with the full disclosure obligations under Regulations S-K and S-X. This has proven challenging for both issuers and the SEC when the security being registered is a digital asset. Among the numerous issues to figure out have been providing a wallet to recipients, the custody of digital securities, the maintenance of a registrar and transfer agent duties, the lack of a licensed operational secondary market, cybersecurity issues, programming the digital security for the myriad of rights it may have (analogous to common stock, or completely different such that it could morph into a utility), selling and distribution methods, and the numerous issues with accepting other digital assets or cryptocurrencies as payment for the registered securities token.
If a placement agent or underwriter is involved, that placement agent or underwriter must not only resolve all of these matters, but additional issues such as escrow provisions, KYC and AML matters and even their own compensation, which typically involves not only cash, but payment in the security being sold either directly or through convertible instruments such as warrants.
These issues have not only added cost to a registration process, but time as well. The SEC has unapologetically informed registrants that the process would not follow the usual comment review timeline. Yet time has been beneficial to the entire industry as the SEC has continued to make efforts to educate its staff and figure out how to help companies successfully register digital securities. At the American Bar Association’s fall meeting in November, SEC Division of Corporation Finance (“Corp Fin”) Director, William Hinman, remarked that about half a dozen ICO S-1’s and a dozen ICO Regulation A+ filings are currently being reviewed by Corp Fin on a confidential basis.
Unlike a registration for the issuance and sale of specified securities, a registration statement under the Exchange Act registers a class of securities and thereafter makes the registrant subject to ongoing reporting requirements. Registration under the Exchange Act provides information about a company and its securities but does not involve an issuance of a security and therefore does not contain disclosures related to offers, sales, issuances, plans of distribution and the like. A registration under the Exchange Act (i.e., a Form 10) is slightly more robust than an annual report on Form 10-K and much less robust than a registration statement under the Securities Act. Although subject to some comment and review, a Form 10 registration statement automatically goes effective 60 days following the date of filing.
In the AirFox and Paragon Coin settlements, the SEC is requiring both companies to file registration statements on Form 10 to register their class of tokens under the Exchange Act. Both companies will thereafter have to file periodic reports with the SEC, including quarterly Forms 10-Q with reviewed financial statements, an annual Form 10-K with audited financial statements and interim Forms 8-K upon certain triggering events. Furthermore, the companies will be subject to the proxy rules under Section 14 of the Exchange Act and insider filing and related requirements under Sections 13 and 16 of the Exchange Act. The settlement also included penalties and an agreement to compensate an investors who elect to make a claim. Interestingly, in its statement, the SEC indicates that “[T]he registration undertakings are designed to ensure that investors receive the type of information they would have received had these issuers complied with the registration provisions of the Securities Act of 1933 (“Securities Act”) prior to the offer and sale of tokens in their respective ICOs.” As described above, I don’t really agree with the statement, but I do agree that the ongoing disclosure will provide information to investors in deciding whether to seek reimbursement or continue to hold their tokens.
Investment Vehicles Investing in Digital Assets
The Investment Company Act of 1940 (“Investment Company Act”) establishes a registration and regulatory framework for pooled vehicles that invest in securities. This framework applies to a pooled investment vehicle, and its service providers, even when the securities in which it invests are digital asset securities. There are several exemptions for private pooled investment funds with Section 3(c)(1) (a fund with less than 100 investors) and 3(c)(7) (a fund with only “qualified purchasers”) being the most commonly utilized. Both exemptions prohibit the fund from making a public offering of its securities. In fact, there are no Investment Company Act exemptions where a company has engaged in a public offering. Separately, the Investment Advisors Act of 1940 (“Advisors Act”) requires the registration of managers and advisors to investment companies.
On Sept. 11, 2018, the SEC issued a settlement Order in the case involving the Crypto Asset Management LP and its principal Timothy Enneking, finding that the manager of a hedge fund formed for the purpose of investing in digital assets had improperly failed to register the fund as an investment company. The Order found that the manager engaged in an unlawful, unregistered, non-exempt, public offering of the fund. The Order also found that the fund was an investment company, and that it had engaged in a public offering of interests in the fund and thus no exemption was available. The Order additionally found that the fund’s manager was an investment adviser, and that the manager had violated the antifraud provisions of the Advisers Act by making misleading statements to investors in the fund.
This case is interesting because it provided the SEC with an opportunity to make a public announcement and provide enforcement-related guidance under the Investment Company Act and Investment Advisors Act related to digital assets for the first time. Although the Investment Company Act does not allow for an exemption where there is a public offering of securities, it does allow exempted funds to utilize Regulation D, Rule 506(c) which, in turn, allows for general solicitation and advertising. Rule 506(c) requires that all sales be strictly made to accredited investors and adds a burden of verifying such accredited status to the issuing company.
In a 506(c) offering, it is not enough for the investor to check a box confirming that they are accredited. Generally speaking, an offering that allows for general solicitation and advertising is considered a public offering (see HERE for more information). However, in a securities law nuance, the legislation implementing Rule 506(c) specifies that if all of the requirements of Rule 506(c) are satisfied, the offering will not be deemed a public offering under the Investment Company Act (see HERE).
The Crypto Asset Management LP made a mistake in that it engaged in general solicitation and advertising, but did not comply with Rule 506(c) by ensuring that all investors were accredited and verifying accredited status. This mistake gave the SEC the opportunity to issue a statement that “[I]nvestment vehicles that hold digital asset securities and those who advise others about investing in digital asset securities, including managers of investment vehicles, must be mindful of registration, regulatory and fiduciary obligations under the Investment Company Act and the Advisers Act.”
Trading of Digital Asset Securities
The SEC has brought multiple enforcement actions and has made public statements related to the secondary trading of digital assets, including the requirement to register as a national securities exchange or be exempt from such registration such as by operating as a broker-dealer ATS (see HERE). To date, although several broker-dealers are registered as an ATS, there is no operational secondary securities digital asset market place. In addition to SEC registration, broker-dealers must be members of FINRA, who regulates specific operations, including related to an ATS (see HERE and HERE).
The SEC’s recent enforcement action against the founder of EtherDelta, a platform facilitating the trading of digital assets securities, underscored the SEC’s Division of Trading and Markets’ ongoing concerns about the failure of platforms that facilitate trading in digital asset securities to register with the SEC or operate under a proper exemption from registration. According to the SEC’s order, EtherDelta, which was not registered with the SEC in any capacity, provided a marketplace for bringing together buyers and sellers for digital asset securities through the combined use of an order book, a website that displayed orders, and a smart contract run on the Ethereum blockchain. EtherDelta’s smart contract was coded to, among other things, validate order messages, confirm the terms and conditions of orders, execute paired orders, and direct the distributed ledger to be updated to reflect a trade. The SEC found that EtherDelta’s activities clearly fell within the definition of an exchange.
An analysis as to whether an entity is operating as an exchange requires a substance-over-form facts-and-circumstances review, regardless of terminology used by the operator. For example, if a system “brings together orders of buyer and sellers” – if, for example, it displays, or otherwise represents, trading interest entered on a system to users or if the system receives users’ orders centrally for future processing and execution – it is likely an exchange. Likewise, a system that uses non-discretionary methods to facilitate trades or bring together and execute orders, may fall within the definition of an exchange.
Even if an entity is not operating as an exchange, or would not require a full ATS license, it may be required to register as a broker-dealer. Entities that facilitate the issuance of digital asset securities or their secondary trading may be required to register as a broker-dealer. Section 15(a) of the Exchange Act provides that, absent an exception or exemption, it is unlawful for any broker or dealer to induce or attempt to induce the purchase or sale of any security unless such broker or dealer is registered in accordance with Section 15(b) of the Exchange Act. Section 3(a)(4) of the Exchange Act generally defines a “broker” to mean any person engaged in the business of effecting transactions in securities for the account of others. Section 3(a)(5) of the Exchange Act generally defines a “dealer” to mean any person engaged in the business of buying and selling securities for such person’s own account through a broker or otherwise. As with the “exchange” determination, a substance-over-form analysis must be applied to assess whether an entity meets the definition of a broker or dealer, regardless of how an entity may characterize either itself or the particular activities or technology used to provide the services.
Further Reading on DLT/Blockchain and ICOs
For a review of the 2014 case against BTC Trading Corp. for acting as an unlicensed broker-dealer for operating a bitcoin trading platform, see HERE.
For an introduction on distributed ledger technology, including a summary of FINRA’s Report on Distributed Ledger Technology and Implication of Blockchain for the Securities Industry, see HERE.
For a discussion on the Section 21(a) Report on the DAO investigation, statements by the Divisions of Corporation Finance and Enforcement related to the investigative report and the SEC’s Investor Bulletin on ICOs, see HERE.
For a summary of SEC Chief Accountant Wesley R. Bricker’s statements on ICOs and accounting implications, see HERE;
For an update on state-distributed ledger technology and blockchain regulations, see HERE.
For a summary of the SEC and NASAA statements on ICOs and updates on enforcement proceedings as of January 2018, see HERE.
For a summary of the SEC and CFTC joint statements on cryptocurrencies, including The Wall Street Journalop-ed article and information on the International Organization of Securities Commissions statement and warning on ICOs, see HERE.
For a review of the CFTC’s role and position on cryptocurrencies, see HERE.
For a summary of the SEC and CFTC testimony to the United States Senate Committee on Banking Housing and Urban Affairs hearing on “Virtual Currencies: The Oversight Role of the U.S. Securities and Exchange Commission and the U.S. Commodity Futures Trading Commission,” see HERE.
To learn about SAFTs and the issues with the SAFT investment structure, see HERE.
To learn about the SEC’s position and concerns with crypto-related funds and ETFs, see HERE.
For more information on the SEC’s statements on online trading platforms for cryptocurrencies and more thoughts on the uncertainty and the need for even further guidance in this space, see HERE.
For a discussion of William Hinman’s speech related to ether and bitcoin and guidance in cryptocurrencies in general, see HERE.
For a review of FinCEN’s role in cryptocurrency offerings and money transmitter businesses, see HERE.
For a review of Wyoming’s blockchain legislation, see HERE.
For a review of FINRA’s request for public comment on FinTech in general and blockchain, see HERE.
For a summary of three recent speeches by SEC Commissioner Hester Peirce, including her views on crypto and blockchain, and the SEC’s denial of a crypto-related fund or ETF, see HERE.
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