The U.S. Securities and Exchange Commission announced two settled enforcement actions on November 16, 2018, imposing registration requirements and civil penalties against issuers of initial coin offerings (ICOs) for failing to register their respective offerings under Section 5 of the Securities Act of 1933.1 These settlements – involving Paragon and AirFox – are the first enforcement actions imposing civil penalties against issuers of digital asset tokens in an ICO for violating the registration requirements of the federal securities laws, in the absence of allegations of fraud.
Later the same day, the SEC’s Divisions of Corporation Finance, Investment Management and Trading and Markets issued a joint statement (Joint Statement) highlighting the SEC staff’s (Staff) enforcement actions and reiterating certain key points with respect to digital asset securities.
AirFox and Paragon Settlements – A Roadmap to Compliance for Unregistered ICOs
Previously, in December 2017, the SEC ordered token issuer Munchee Inc. to discontinue its token offering and refund investors without imposing civil penalties.2 The current settlements, in contrast, impose civil penalties on the issuers and require them to undertake remediation efforts that include registration of the tokens as securities under the Securities Exchange Act of 1934. The SEC determined that the ICOs and token presales conducted by AirFox and Paragon constituted the offer and sale of securities under the Securities Act. In the orders, the SEC reiterated (as first announced in the DAO Report)3 that the correct test for the determination of whether a digital asset is a security is the Howey Test.4 According to the SEC, token sales in both AirFox and Paragon were “investment contracts” that are required to be offered in accordance with SEC registration requirements or an applicable exemption.
The settlements require AirFox and Paragon to file Form 10 with the SEC within 90 days of the respective orders to register their tokens as a class of securities under the Exchange Act. Each issuer is also required to file periodic reports under the Exchange Act for at least one year. These reports are intended to furnish holders of the digital asset securities with sufficient information to evaluate their investment, and provide disclosure of the type required by the Exchange Act. Given that no digital asset security has yet been registered under the Exchange Act, it is not clear from the orders how the issuers will approach their disclosure obligations and the scope of information that will be provided.
In addition to the registration requirements, AirFox and Paragon will be required to provide an SEC approved “claim form” to all token purchasers who had purchased tokens in the presale or ICO. Such purchasers will be entitled to receive the consideration paid plus interest (less the amount of any income received thereon) in exchange for tender of their tokens. Notably, the SEC did not specify whether consideration would be returned in the form it was originally received (e.g., bitcoin, ether or other digital assets used to purchase tokens in the presale or ICO) or whether it would be returned in U.S. dollars at the U.S. dollar equivalent rate at the time of investment. While AirFox’s claim form indicates that claims will be paid in U.S. dollars based on the value at time of purchase, it is not clear whether this was a requirement of the settlement or will be required in future settlements. Each company was also fined $250,000.
The orders leave significant questions unaddressed. For example, the orders do not indicate how or whether the SEC will adapt its disclosure and reporting regime to accommodate the registration of a digital asset security or a digital asset security issuer. Nor do the orders indicate whether token holders who decline the repurchase offer will hold tokens that are immediately freely tradable under the federal securities laws.
The Joint Statement – A Summary of Enforcement Actions and Reiteration of Division Positions
The Joint Statement highlights recent enforcement actions that fall into the following categories: (i) offers and sales of unregistered digital asset securities; (ii) investment vehicles and investment advisers that invest in digital asset securities; and (iii) trading of digital asset securities.
Offers and Sales of Unregistered Digital Asset Securities
The Staff noted that enforcement actions involving the offer and sale of digital asset securities have focused primarily on whether the assets were securities and, if so, what federal securities laws applied. Discussing the AirFox and Paragon orders, the Staff indicated that the settlements show a “path to compliance” for companies that have already conducted an unregistered offering of digital asset securities. In the settlements, in addition to paying penalties, the companies agreed to register their respective tokens as securities with the SEC and compensate those investors who purchased unregistered tokens and elect to make a claim for rescission.
Investment Vehicles and Investment Advisers Investing in Digital Asset Securities
The Staff noted that the Investment Company Act of 1940 requires the registration of, and provides a regulatory framework for, pooled investment vehicles that invest in digital asset securities and their service providers. By way of example, the Staff discussed the application of the 1940 Act in a recent enforcement action against the manager of what the SEC alleged was an unregistered investment company that invested in digital asset securities.5 In addition, the SEC further alleged that the manager itself was operating as an unregistered investment adviser, which gave rise to alleged violations of the Investment Advisers Act of 1940. The Staff also indicated in a footnote that the federal securities laws apply to the offer and sale of interests in pooled investment vehicles as well, regardless of whether the interests in such investment vehicles utilize new technologies, including blockchain.
Trading of Digital Asset Securities
The Staff devoted a substantial portion of the statement to discussing the application of the federal securities laws governing securities exchanges and broker-dealers to companies that operate platforms for trading digital assets or engage in other activities that facilitate the trading of such assets.
Registration as a National Securities Exchange
The Staff explained that a platform that allows users to trade digital asset securities and otherwise meets the definition of an exchange under the Exchange Act must either register with the SEC as a national securities exchange or qualify for a registration exemption, such as by registering instead as an alternative trading system (ATS) under Regulation ATS. From this perspective, the Staff addressed decentralized exchanges by reference to a recent enforcement order against the founder of EtherDelta for operating an unregistered securities exchange.6
Turning to the question of when a digital asset trading platform may be a securities exchange, the Staff further explained that the Exchange Act and the rules promulgated thereunder apply a functional test to determine whether a platform is a securities exchange, noting that the activity between buyers and sellers on the platform, and not the technology being used, is the determinative factor.
As background, Rule 3b-16 under the Exchange Act provides a two-part test for determining when a platform provides “a market place or facilities for bringing together purchasers and sellers of securities or for otherwise performing with respect to securities the functions commonly performed by a stock exchange” for purposes of meeting the definition of an “exchange” under the Exchange Act.7 The first part of the test is whether the platform “[b]rings together the orders for securities of multiple buyers and sellers.” The second part of the test is whether the platform “[u]ses established, non-discretionary methods (whether by providing a trading facility or by setting rules) under which such orders interact with each other, and the buyers and sellers entering such orders agree to the terms of a trade.”
With respect to the first prong of Rule 3b-16, the Staff stated that a platform would be considered as “bringing together orders of buyer[s] and sellers” if the platform displays to users a “trading interest” of digital asset securities entered on the platform or receives orders for digital asset securities “centrally for future processing and execution.” With respect to the second prong of Rule 3b-16, the Staff noted that a platform that “provides a trading facility or sets of rules” is considered to be using “established non-discretionary methods.” The Staff provided the following examples of when a platform employing blockchain or other new technologies could potentially be deemed to be establishing non-discretionary methods:
- “An entity that provides an algorithm, run on a computer program or on a smart contract using blockchain technology, as a means to bring together or execute orders could be providing a trading facility.”
- “An entity that sets execution priorities, standardizes material terms for digital asset securities traded on the system, or requires orders to conform with predetermined protocols of a smart contract, could be setting rules.”
The Staff also explained that an entity that “arranges for other entities, either directly or indirectly, to provide the various functions of a trading system that together meet the definition of an exchange” may be deemed to be a securities exchange.
Registration as a Broker-Dealer, Transfer Agent or Clearing Agency
The Staff stated that a company that facilitates the initial offering or trading in secondary markets of digital asset securities could be deemed a “broker” or “dealer” under the Exchange Act, and may therefore need to register with the SEC as a broker-dealer and become a member of the Financial Industry Regulatory Authority (FINRA). The Staff pointed to a recent enforcement action in which an alleged unregistered broker-dealer operated a platform on which users could purchase digital asset securities, including assets issued in ICOs.8 Through the platform, the company accepted users’ orders for digital asset securities and disbursed the payment of funds to issuers, and received as compensation a percentage of the ICO proceeds and a guaranteed minimum commission.
Although the SEC to date has not yet brought an enforcement action against a company for operating as an unregistered transfer agent or clearing agency, the Staff also indicated in a footnote to the Joint Statement that companies should consider the possible application of transfer agent and clearing agency registration requirements.
The Joint Statement appears to be an attempt by the Staff to distill practical guidance from a growing body of SEC enforcement actions, to help companies that provide services in the area of digital assets to comply with the federal securities laws, with a particular emphasis that the existing legal framework continues to apply regardless of technological innovation. The Joint Statement and the orders demonstrate an effort by the SEC to balance a commitment to investor protection with the promotion of innovation in financial markets. Notably, the SEC has indicated that it will allow the tokens issued in unregistered, illegal offerings to remain outstanding, even though the issuer will need to conduct a rescission offer. Companies that engage in activities involving digital assets should review their business models in light of the guidance provided in the Joint Statement to determine whether registration with the SEC of the securities or the entity is required.