These days it seems that everybody is considering getting into the distributed ledger technology business causing the United States Securities and Exchange Commission (“SEC”) and the securities plaintiffs’ bar to take notice. Over the past several years the SEC has made certain public remarks about this new technology and brought a few enforcement actions. However, its recent investigative report addressing the initial coin offering (“ICO”) of a virtual organization (“21(a) Report”)1 marks a dramatic increase in the SEC’s focus that will have a profound impact on how this emerging market will be regulated. The report also signals an eventual uptick in enforcement activity and supplies plaintiffs’ attorneys with a new weapon for their complaints. As discussed in this article, the 21(a) Report therefore has far-reaching implications to the creation, offer, and sale of ICOs as well as the promotional and investment activities relating to them.
The 21(a) Report and Its Regulatory Implications
While it may have been previously unclear whether the federal securities laws applied to ICOs and other distributed ledger applications, it is now apparent from the 21(a) Report that such applications trigger those laws under certain facts and circumstances.2 In its release accompanying the 21(a) Report, the SEC emphasized that “the federal securities laws apply to those who offer and sell securities in the United States, regardless whether the issuing entity is a traditional company or a decentralized autonomous organization, regardless whether those securities are purchased using U.S. dollars or virtual currencies, and regardless whether they are distributed in certificated form or through distributed ledger technology.”3
By way of background, the 21(a) Report relates to The DAO, a virtual organization embodied in computer code and executed on a distributed ledger. The DAO was created to operate as a for-profit entity that would be capitalized by the sale of DAO Tokens to investors. The DAO’s assets would then be used to fund projects selected by certain holders of DAO Tokens. In return, The DAO would receive earnings from funding these projects. Holders of DAO Tokens could also monetize their investments by selling their tokens on various web platforms.
Based on its investigation of The DAO, the SEC issued the 21(a) Report to advise that, depending on the facts and circumstances, the federal securities laws likely apply to situations in which distributed ledger or blockchain technology is used to raise capital. With respect to The DAO, the SEC found that the federal securities laws applied to various activities relating to the creation, offer, and sale of its tokens. In particular, the SEC found that (i) The DAO was acting as an unregistered issuer, (ii) the DAO Tokens were securities, and (iii) the platforms that facilitated the offer and sale of DAO Tokens were acting as unregistered exchanges. Because The DAO did not, by the time of the 21(a) Report, fund any project, the SEC did not analyze whether anyone associated with The DAO was acting as an investment adviser or an investment company. However, the SEC encouraged market participants under similar circumstances to consider their obligations under the Investment Advisers Act of 1940 and Investment Company Act of 1940. Market participants should similarly consider whether they are acting as a broker or dealer requiring registration under the Securities Exchange Act of 1934.
Since issuing the 21(a) Report, the SEC has brought several enforcement actions relating to ICOs. For example, the SEC filed a lawsuit and obtained an asset freeze on September 29, 2017, against two companies and their principal for anti-fraud and registration violations of the federal securities laws relating to a pair of ICOs that defendants claimed were backed by investments in real estate and diamonds.4 Among other things, the SEC’s complaint alleges that defendants misrepresented that investors would receive sizeable returns on their investments even though the companies did not have any real operations. For example, investors were allegedly led to believe that one of the companies had a “team of lawyers, professionals, brokers, and accountants” to support its investments into real estate when none were hired or consulted. The complaint also alleges that the principal and his real estate company misrepresented that they had raised between $2 million and $4 million even though they had only raised approximately $300,000 from investors. This case is currently pending.
Then, on December 4, 2017, the SEC’s Cyber Unit filed its first lawsuit and obtained an asset freeze against a Canadian couple and their company for anti-fraud and registration violations of the federal securities laws relating to a “fast moving” ICO that allegedly raised over $15 million on the false promise that investors would earn a thirteen-fold profit in one month.5 Among other things, the SEC’s complaint alleges that defendants misrepresented that they had a global team (even though they only had a handful of employees in Quebec), their executives needed to be anonymous to avoid poaching (when in fact one of them was a “known recidivist securities law violator in Canada”), the proceeds of the ICO would go to product development (as opposed to lining the defendants’ pockets), and the ICO’s tokens would experience “enormous” returns (when there was no reasonable basis for such a claim). The complaint also alleges that defendants attempted to “skirt” the registration requirements of the federal securities laws by fashioning their tokens as a cryptocurrency, when in fact they are securities that fit within the meaning of investment contracts. This case is also currently pending.
A week later, on December 11, 2017, the SEC announced the Cyber Unit’s second enforcement action.6 This time it was a settled order against a California company for allegedly selling digital tokens to raise capital for its iPhone application for restaurant reviews. According to the order, the company sought to raise $15 million in Ether or Bitcoin to create an ecosystem within its existing application where its tokens would be used to pay users for writing reviews and for restaurants to purchase advertising. As part of its finding that the tokens were a security, the order alleged that the company emphasized in its marketing materials that it would create a secondary market for the tokens where investors would be able to generate a return on their investment. Because the company stopped selling its tokens hours after being contacted by the SEC and promptly returned the proceeds it received, the sanctions against the company were limited to a no-admission settlement that did not impose any civil penalty, disgorgement, or bar.
On the same day, SEC Chairman Jay Clayton issued a public statement on cryptocurrencies and ICOs noting his support for them as “effective ways for entrepreneurs and others to raise funding, including for innovative projects.”7 Chair Clayton, however, cautioned gatekeepers to “be guided by the principal motivation for [the United States’] registration, offering process and disclosure requirements… [of] investor protection” when advising the structuring and obligations of these new business activities. Chair Clayton emphasized that “the potential for profits based on the entrepreneurial or managerial efforts of others continue to [be] the hallmarks of a security under U.S. law.”
The SEC’s Enforcement Division and Office of Compliance Inspections and Examinations have also recently warned that celebrity endorsements on social media networks that promote a particular ICO “may be unlawful if they do not disclose the nature, source and amount of any compensation paid, directly or indirectly, by the company in exchange for the endorsement.”8
In light of all this, those involved with ICOs or other applications of blockchain technology should carefully consider whether their activity falls under the SEC’s securities law interpretations in its 21(a) Report. Among other things, market participants should consider obtaining a legal opinion from counsel on whether, and to what extent, the securities laws apply to their activity, particularly if it involves forming, facilitating, or promoting a blockchain technology to raise capital. Counsel can flag issues that are not readily apparent and provide guidance on how to comply with the federal securities laws. Depending on their particular facts and circumstances, market participants might also consider seeking no action relief from the SEC through their attorneys—a way in which parties may obtain the SEC’s opinion on interpretations of the federal securities laws based on certain factual representations. In any event, to the extent the SEC may question a market participant’s activities, counsel should play a critical role in responding to an investigation, particularly where, as here, the law is still developing and is not yet informed by a formal rule or court decision. Early missteps in the ICO or resulting investigation can be costly and result in perhaps avoidable enforcement proceedings.
Beware the Securities Plaintiffs’ Bar
Although the SEC declined to take action against The DAO for its unregistered public offerings, the securities plaintiffs’ bar has seized the opportunity to use the SEC’s findings for itself. A series of securities class actions, collectively referred to as the “Tezos Class Actions,” were recently filed against Dynamic Ledger Solutions, Inc., its founders Kathleen and Arthur Breitman, Tezos Foundation, and other affiliates (collectively “Tezos”). The legal theory underlying these class actions is that the cryptocurrency promoted by Tezos is a “security” and, hence, Tezos’s conduct is subject to the federal securities laws.The securities class plaintiffs accuse Tezos of misrepresenting the nature of its ICO back in July 2017, when it raised $232 million as part of its mission to develop its own blockchain network that would compete against bitcoin and ethereum as a newer and better iteration of existing blockchain technology.
For this ICO, Tezos initiated a “fundraiser” whereby “contributors” or “donors” could make “non-refundable donations,” in the form of bitcoin or ether, to the Tezos Foundation. Upon the completion of the Tezos blockchain, the foundation would then “recommend” the donors receive a certain amount of Tezos Tokens (“XTZ” or “Teezies”) proportionate to their donation. According to the class plaintiffs, despite the enormous amount of funds raised during the two-week ICO, the Tezos blockchain still has not launched, and recent public statements by Tezos that estimate a launch date in February 2018 undermine the possibility of the project ever reaching completion.
According to the securities plaintiffs, Tezos fraudulently and deceptively marketed the ICO and improperly pocketed the proceeds from the ICO for themselves. Explicitly relying on the 21(a) Report, these plaintiffs assert the July ICO was a non-exempt, unregistered offer and sale of securities that violated, among other laws, Sections 5(a) and 5(c) of the Securities Act of 1933 and the anti-fraud provisions of Section 17(a) of the Securities Act.9 Tezos has yet to answer these claims or move to dismiss them. A finding of liability could require as a remedy rescission of the ICO and return of the funds to “donors”.
The Tezos class actions are the first class actions brought against cryptocurrency promoters under the federal securities laws. Prior to the 21(a) Report and the Tezos Class actions, cryptocurrency investors filed class actions against promoters under state tort laws. For example, in Liu v. Project Investors, Inc., the plaintiffs sued a cryptocurrency trading website known as “Cryptsy” and its owner, Paul Vernon, under state tort law for lying to their customers about the solvency of the company and status of their funds, improperly denying users access to their accounts, and misappropriating approximately $5 million worth of Bitcoin in those accounts.10 The claims included negligence, conversion, unjust enrichment, fraudulent conveyance, and conspiracy.
But, now, cryptocurrency issuers, promoters, and other market participants should beware of the securities plaintiffs’ bar. Until a court holds otherwise, ICOs may, depending on the facts and circumstances, be securities under the federal securities laws. Although the SEC has not yet promulgated regulations, the plaintiffs’ securities bar can now wield the 21(a) Report to avail itself of the well-established and feared federal securities laws. As noted, these laws could allow plaintiff classes in securities class actions to recover significant monetary damages or rescission from cryptocurrency issuers and promoters who knowingly mislead investors. They could also impose strict liability on issuers of cryptocurrencies who fail to file a registration statement or issue one with material misrepresentations or omissions. This is precisely what could happen in the securities class action Rensel v. Centra Tech, Inc., where those responsible for the Centra ICO—which raised over $30 million between July and October this year—are facing class action claims under sections 12(a)(1) and 15(a) of the Securities Act of 1933.11 The gravamen of these claims is that the cryptocurrency the defendants offered as part of the ICO qualifies as a “security” and, hence, the defendants are liable under these laws simply for offering an unregistered security.
It should also be noted that the cryptocurrency industry’s lack of regulation and consistency make it especially vulnerable to plaintiffs’ law firms that are constantly looking for any reason to bring a class action. For example, it is increasingly common for cryptocurrency exchanges to experience technological malfunctions because their systems are ill-equipped to handle growing consumer demand. This is what recently happened with the California-based cryptocurrency exchange known as the “Kraken,” which earlier this year experienced significant delays due to the number of investors attempting to use it to trade cryptocurrencies. Certain of those investors have since sued those responsible for the Kraken exchange to recover damages they suffered as a result of those delays. Ironically, if this industry were better regulated, such issues might never have occurred in the first place.
Still, market participants should have many defenses available to them as they face the ensuing onslaught from the securities plaintiffs’ bar. The chief defense is whether the cryptocurrency in question is in fact a “security” under the federal securities laws. As noted earlier, the 21(a) Report remains largely untested and it is very possible that federal judges will take a less expansive view of the federal securities laws than the SEC. Moreover, even the SEC noted in its 21(a) Report that not all cryptocurrencies are “securities” and not all ICOs are “offerings” under the federal securities laws. Each case is different and will likely turn on whether the relevant facts support all three prongs of the so-called “Howey Test” the SEC referenced in its 21(a) Report. The Howey test provides that a security exists where there is: (i) an investment of money; (ii) in a common enterprise; and (iii) with an expectation of profits predominantly from the efforts of other users.12 For example, some cryptocurrencies may fail the “common enterprise” prong of the Howey Test because some circuits limit this prong to situations where the investor’s success depends on the promoter’s expertise. For cases brought in those circuits, courts could hold that some cryptocurrencies are not securities if the issuer has little to no influence on the success of the investment, because that would mean that a common enterprise would be lacking. This is particularly so if the issue is not actively involved in facilitating a secondary market or exchange for its currency.
Finally, it should be noted that, because many of the companies responsible for issuing or promoting cryptocurrencies are not registered in the United States or lack substantial U.S. connections, the cryptocurrency industry as a whole is less vulnerable to domestic private class action litigation. Even though investors may be able to legally sue foreign cryptocurrency promoters and issuers in U.S. federal court, investors may not be able to recover from these defendants since their assets are parked overseas. This, and the fact that most cryptocurrencies are not purchased with fiat currency, may serve as disincentives to the securities plaintiffs’ bar since these firms are traditionally compensated by a portion of the ultimate recovery, not on an ongoing basis.
In many ways, the SEC’s finding that ICOs under particular facts and circumstances are securities could threaten the appeal that cryptocurrencies initially offered certain entrepreneurs. Many of them entered the cryptocurrency industry to bypass government and central bank controls and take advantage of a largely unregulated investment market and decentralized economy. But now it appears that these institutions, at least those physically in or operating in the United States, would still be subject to the extensive federal securities laws and regulations. Failure to abide by these laws and regulations would otherwise open them up to SEC investigations and enforcement actions and endless private securities class actions. Accordingly, if the courts continue to affirm the SEC’s conclusion about ICOs, it may lead many cryptocurrency issuers and traders to exit the industry as fast as they entered because participating in this ever-changing unregulated industry may end up posing too much legal risk and financial cost. Still, this is way too early to prognosticate on how the 21(a) Report will impact the cryptocurrency industry. A lot can change and no court has yet to weigh in on whether the SEC’s finding that ICOs are securities is correct.
Given all this, it is important for anyone engaging in a business involving cryptocurrencies or distributed ledger or blockchain technology to obtain experienced SEC counsel on how their business activities may implicate the securities laws.