Gladius Network LLC settled allegations by the Securities and Exchange Commission that its initial coin offering of GLA tokens intended to be used as the currency for its blockchain-enabled cybersecurity service constituted an offering of unregistered securities in violation of applicable law. Although Gladius’s Terms and Conditions of Token Sale expressly noted that GLA tokens were “not being structured or sold as securities or any other form of investment product,” the SEC said that the firm’s principals and agents discussed the prospects for investment returns from GLA tokens on various social media; Gladius took steps to have GLA tokens traded on significant digital asset trading venues; and Gladius pronounced after the ICO that it entered into a “partnership” to list GLA tokens on “one of the top cryptocurrency exchanges in the world.” 

As a result, said the SEC, purchasers of GLA tokens “would have reasonably expected that they could obtain a future profit from GLA [t]okens if the entrepreneurial and managerial efforts of Gladius’s founders, employees and agents succeeded” regardless of whether they ever used the Gladius service. The SEC said that GLA tokens were therefore securities relying on the Supreme Court’s 1946 decision, SEC v. W.J. Howey (click here to access).

The SEC did not charge that Gladius committed any fraud in connection with its ICO.

To resolve the SEC’s allegations, Gladius agreed to register GLA tokens as a class of security and compensate investors, among other undertakings. However, the SEC imposed no fine on Gladius because of the firm’s remedial steps, including its self-reporting of a possible securities law violation and cooperation with SEC staff. 

In November 2018, the SEC filed and settled two enforcement actions against issuers of ICOs – Carrier EQ Inc. d/b/a/ AirFox and Paragon Coin, Inc. – for violating securities registration requirements. These cases represented the first time the SEC assessed fines in connection with a non-fraudulent ICO.

At the same time it published the AirFox and Paragon settlement orders, the SEC’s Divisions of Corporation Finance, Investment Management and Trading and Markets issued a “Statement of Digital Asset Securities Issuance and Trading” that, among other things, noted that the two settlements provided a “path to compliance” for prior issuers of unregistered or not lawfully exempt cryptosecurities. (Click here for background regarding the SEC’s Divisions’ statement as well as the AirFox and Paragon settlement in the November 18, 2018 edition of Bridging the Week.)

In other legal and regulatory developments involving cryptoassets:

  • Person Claiming to Be Satoshi Nakamoto Among 34 Responders to CFTC RFI Regarding Ether: The Commodity Futures Trading Commission received 34 letters in response to its December 2018 request for information related to ether – the cryptocurrency designed as the “fuel” of the Ethereum blockchain network – including from one individual – Craig Wright – who claimed to be Satoshi Nakamoto, the developer of bitcoin. Few of the commentators addressed all of the CFTC’s 25 asked questions, but many persons addressed the planned migration of Ethereum from its current proof of work to proof of stake consensus mechanism and whether POS has any “particular vulnerabilities.” FIA Principal Traders Group for example, conjectured that all POS methods “run some risk of becoming more centralized entities where a few participants conduct the lion’s share of verifying transactions.” Coin Desk acknowledged that “the chance of validating a block will be proportional to staked wealth,” but said that this is not a vulnerability but the “intent” of the protocol design. Moreover, the public nature of a blockchain would mitigate against an attacker that presents an alternative history (e.g., to cause a double-spend) and, in any case, a POS system can be designed to forbid block reorganizations beyond more than a certain number of prior blocks and to punish wrongdoers. The Ethereum Foundation expressly noted that, in designing Ethereum’s POS, developers are “taking measures to ensure that proof of stake favors smaller and more decentralized participants” including imposition of an “anti-correlation penalty” against persons who appear to be trying to gang together in highly correlated activity.

The person claiming to be Satoshi Nakamoto offered that “Ethereum is a poorly designed copy of bitcoin designed with the purpose of completing the promise of smart contracts and scripting that were delivered within bitcoin but which were hobbled by the core developers of bitcoin who sought to enable anonymous transactions to exist within the system.”

  • ISDA Provides Guidance for Programming Smart Contracts to Effectuate OTC Derivatives Master Agreement: The International Swaps and Derivatives Association issued its second paper offering legal guidelines for smart contracts, stressing certain key elements of the ISDA Master Agreement that should be preserved when developing technological applications. However, ISDA does not believe that all provisions of the ISDA Master Agreement are “well suited or efficient to code.” In its paper, ISDA provides specific technological considerations for provisions dealing with events; payments and deliveries, close out and netting; disputes; and contract formation and legal relations. Among other things, ISDA recommends that, to anticipate the possibility that the commercial intent of the parties may not be accurately reflected in code, a smart contract should include a provision stating that the “natural language version of the contract will prevail in the event of any inconsistencies.”

Legal Weeds: Oral arguments are scheduled for March 13, 2019, in the Commodity Futures Trading Commission’s appeal of the decision of a US district court in California, dismissing its enforcement action against Monex Deposit Company and other defendants. In 2017, the CFTC charged Monex with engaging in illegal off-exchange futures transactions because it entered into leveraged transactions to retail persons without making actual delivery within 28 days, and with committing fraud, relying on authority under the Dodd-Frank Wall Street Reform and Consumer Protection Act. The oral argument will be held at the US Ninth Circuit Court of Appeals sitting in San Francisco.

The district court rejected the CFTC’s legal theories, holding that actual delivery of precious metals in financed transactions to retail persons falls outside the CFTC’s jurisdiction when ownership of real metals is legally transferred to such persons within 28 days. This is the case even if the seller retains control over the commodities because of financing beyond 28 days. The court also held that the CFTC cannot use the Dodd-Frank enacted prohibition against persons engaging in any manipulative or deceptive device or contrivance in connection with the sale of any commodity in interstate commerce to prosecute acts of purported fraud except in instances of fraud‑based market manipulation. (Click  here for background on the district court’s decision in the article “California Federal Court Dismissal of CFTC Monex Enforcement Action Upsets Stable Legal Theories” in the May 6, 2018 edition of Bridging the Week.)

In its appeal, the CFTC argued that the district court was wrong on the law in its analysis of both provisions.

First, the CFTC argued that the Dodd-Frank provision prohibits the type of fraud it charged. (Click here to access the relevant provision of law, 7 U.S.C § 9(1).) The Commission said the district court came to its incorrect conclusion by rewriting the statute (i.e., saying that “manipulative or deceptive device” should be read as “manipulative and deceptive device”). However, this is inconsistent with the intent of Congress in drafting this provision which was to mimic the anti-fraud provision of the Securities and Exchange Commission (Click here to access SEC Rule 10b-5).

Second, the Commission said that the phrase “actual delivery” in the relevant statute means the “formal act of transferring something” and must involve “a transfer of possession and control.” The CFTC argued that Monex’s purported delivery only involved a bookkeeping entry and provided no control to customers – until they repaid the amount they borrowed to purchase or sell the commodity. Accordingly, the Commission had jurisdiction to bring its enforcement action. (Click here to access the relevant provision of law, 7 U.S.C § 2(c)(2)(D)(ii)(III).)

The outcome of this appeal with have implications beyond the precious metals industry as the CFTC employs its § 9(1) authority broadly, and has used the actual delivery provision of law to prohibit leveraged trading involving cryptocurrencies on non-registered exchanges. (Click here for background in the article “Bitcoin Exchange Sanctioned by CFTC for Not Being Registered” in the June 5, 2015 edition of Bridging the Week.)