The ICO TKO? U.S. authorities come out swinging in the latest round of enforcement and regulatory guidance on crypto assets

Fintech The ICO TKO? Authorities come out swinging in the latest round of enforcement and regulatory guidance on crypto assets As the original cryptocurrency, Bitcoin was created to be a radical alternative to the existing international payments system, where a ‘trusted intermediary’ was replaced by a decentralized network of users. However, as its popularity has grown and the market for cryptocurrency has expanded to include more than 2,3001 different virtual currencies exchanged around the world, the objective of decentralization is becoming increasingly incompatible with systems of regulation that are designed to protect investors and consumers. In the United States, this tension has resulted in regulators setting their sights on Bitcoin, other cryptocurrencies and crypto assets such as “tokens,” as well as the exchanges and brokers which investors and consumers use to access this nascent market. Key Takeaways:  U.S. regulators have surveyed the cryptocurrency markets and found them lacking in basic customer protections.  Regulatory enforcement against exchanges and brokers who facilitated trading in unregistered securities will likely pick up in the near term.  This regulatory scrutiny will continue to have a chilling effect on the already cooling market for ICOs. Introduction After a period of détente during the summer, including a widely-read speech in June by a senior official at the U.S. Securities and Exchange Commission (the “SEC”) which stated that neither Bitcoin nor Ether are securities, and that offers and sales of these cryptocurrencies are not securities transactions,2 the month of September saw a flurry of activity from the Federal courts, securities regulators and the New 1 According to Investing.com’s current list, 2,324 cryptocurrencies have launched as of September 27, 2018. Available at https://www.investing.com/crypto/currencies. 2 Hinman, William, Digital Asset Transactions: When Howey Met Gary (Plastic), Remarks at the Yahoo Finance All Markets Summit: Crypto (June 14, 2018). Available at https://www.sec.gov/news/speech/speech-hinman-061418. 3 Cohney, Shaanan and Hoffman, David A. and Sklaroff, Jeremy and Wishnick, David A., Coin-Operated Capitalism (July 17, 2018). Available at SSRN: https://ssrn.com/abstract=3215345 or http://dx.doi.org/10.2139/ssrn.3215345. York Office of the Attorney General, amongst others. This activity included the following:  On September 18, the New York State Office of the Attorney General released a report which addresses areas of concern regarding the transparency, fairness and security of virtual asset trading exchanges.  On September 11, the SEC issued two cease and desist orders against several entities and individuals, involving allegations that the parties were intermediaries offering and selling initial coin offering (“ICO”) tokens as unregistered broker-dealers.  On September 11, the Financial Industry Regulatory Authority (“FINRA”) charged Timothy Ayre, who was registered with a FINRA member broker-dealer but acting outside of that capacity, with securities law violations in connection with the public offering and sale of unregistered cryptocurrency securities.  On September 11, the EDNY ruled in United States v. Zaslavskiy that an action against a defendant, alleged to have engaged in a fraudulent offering of virtual securities, could not be dismissed on the grounds that the digital tokens were not securities. The case is one of the first to consider the applicability of federal securities laws in a criminal case involving digital securities or tokens. The recent enforcement activity aligns with academic research published in recent months regarding ICOs and their significant rate of failure to deliver on their contractual promises, 3 along with the New York Attorney General’s report that digital asset exchanges are also not currently up to par regarding investor protection. These findings highlight the value in regulation, even as crypto proponents argue that code obviates the need for regulation or law. Cryptocurrency Exchanges The VMI Report On September 18, the New York State Office of the Attorney General (the “OAG”) released a report entitled “The Virtual Markets Integrity Report” (the “VMI Report”),4 which addresses areas of concern regarding the transparency, fairness and security of virtual asset trading exchanges, and highlights key policies and practices of the exchanges that participated in the OAG’s inquiry.5 The information provided by the participating exchanges formed the basis of the VMI Report. According to the OAG, the provided responses revealed three broad areas of concern, including: (1) the various business lines and operational roles of trading platforms create potential conflicts of interest; (2) trading platforms have yet to implement serious efforts to impede abusive trading activity; and (3) protections for customer funds are often limited or illusory. In the VMI Report, the OAG made the following recommendations:  Customers should know what standards a platform uses to evaluate the virtual assets they list and should receive some assurance that assets traded on the venue conform to those standards. The OAG suggests that platforms that have not disclosed their listing standards publicly should consider doing so.  Exchanges generally do not disclose the compensation, if any, received for listing a particular virtual currency. The OAG suggests that disclosure of payments or other compensation would allow customers to better understand a platform’s incentives in offering or promoting a virtual currency. 4 “The Virtual Markets Integrity Report”, OFFICE OF THE NEW YORK STATE ATTORNEY GENERAL, BARBARA D. UNDERWOOD, ATTORNEY GENERAL (Sept. 18, 2018), available at https://virtualmarkets.ag.ny.gov/. 5 The OAG sent questionnaires to thirteen major exchanges as part of their inquiry into the policies and practices of these platforms. Of the thirteen, nine participated: Bitfinex, bitFlyer USA, Bistamp, Bittrex, Coinbase, Gemini, itBit, Poloniex, and Tidex. HBUS, a platform that is a “strategic partner” of Huobi, Inc., responded to the inquiry, and its responses are included in the VMI Report. The four platforms that declined to participate in the inquiry were: Binance, Gate.io, Huobi Global Limited, and Kraken. 6 Williams-Grut, Oscar, Only 48% of ICOs were successful last year — but startups still managed to raise $5.6 billion, BUSINESS INSIDER (Jan. 31, 2018). Available at https://www.businessinsider.com/how-much-raised-icos-2017-tokendata-2017-2018-1. 7 Floyd, David, $6.3 Billion: 2018 ICO Funding Has Passed 2017's Total, COINDESK (Apr. 19, 2018). Available at https://www.coindesk.com/6-3-billion-2018-ico-fundingalready-outpaced-2017/. 8 House Appropriations Subcommittee on Financial Services and General Government Hearing on FY 2019 SEC Budget Request, SIFMA (Apr. 25, 2018). Available at https://www.sifma.org/resources/general/house-appropriations-subcommittee-on-financial-services-and-general-government-hearing-on-fy-2019-sec-budget-request/.  While all participating platforms reported to offer two-factor authentication for customers in certain circumstances, the OAG notes that the better practice would be to require two-factor authentication as a default practice. The VMI Report also sets out a number of what it identifies as “basic” questions that customers should expect every platform to be able to answer, including:  What insurance, capital buffer, or other policies are in place to make customers whole in event of a theft of virtual or fiat currency?  What controls does the platform maintain to keep unauthorized or abusive traders off the venue?  What policies are in place to prevent the company and its employees from exploiting non-public information to benefit themselves at the expense of customers?  What steps does the platform take to promote transparency and to subject its security, its virtual and fiat accounts, and its controls to independent auditing or verification?  Is the platform subject to, and registered under, banking regulations or a similar regime – for instance, the New York BitLicense regulations? The VMI Report pointedly criticizes many aspects of the operations of virtual currency exchanges, from transparency for participants on the markets, to security, to the robustness of internal controls and procedures. The VMI Report also applies several hotly debated securities market structure concepts, such as automated and high-speed trading and maker-taker pricing, to virtual currency markets and, in doing so, concludes that some trading practices and policies of the surveyed exchanges may advantage institutional market participants over retail participants. And, while the VMI Report is silent on whether the OAG may be considering further investigation or action against these exchanges, it states that the OAG has referred three of the four exchanges that did not respond to its questionnaire to the New York Department of Financial Services for further review. Enforcement Activities The coordinated enforcement effort by the SEC and FINRA follows the meteoric rise of ICOs in 2017. Starting in relative obscurity at the outset of 2017, by midyear, ICOs had quickly grown to account for more startup funding in blockchainbased companies than all of venture capital and by yearend, a reported U.S.$5.6 billion6 had been raised in ICOs. The first quarter of 2018 alone surpassed this number, growing to U.S.$6.3 billion.7 In light of the swelling wave of crypto asset activity, the U.S. House of Representatives Committee on Appropriations held a hearing with the SEC in April 2018 to explore regulation of cryptocurrencies. At the Appropriations Committee Meeting, SEC Chairman Jay Clayton recognized the “economic utility” and “great promise” that cryptocurrencies bring to bear, but Clayton also noted that the growth has occurred “without the usual respect for the law that you would expect to see in the financial markets.” 8 SEC cease and desist orders As part of the September 11 enforcement effort, the SEC issued two cease and desist orders against several entities and individuals, involving allegations that the parties were intermediaries offering and selling ICO tokens as an unregistered broker-dealer or investment company. Each of the actions is based on the premise, now generally accepted in the market, that many types of digital assets may be, and often are, securities. The Matter of Crypto Asset Management, LP and Timothy Enneking9 In a first order, the SEC issued a cease and desist order against Crypto Asset Management LP (the “Manager”), a digital asset hedge fund manager, which had raised an investment fund, Crypto Asset Fund LLC (“CAF”), for the purpose of investing in digital assets. Timothy Enneking is the founder and sole principal of the Manager. Neither the Manager nor Enneking has ever been registered with the Commission in any capacity. The Manager marketed CAF as the “first regulated crypto asset fund in the United States” and, per the cease and desist order, was generally soliciting the public in relation to CAF through the Manager’s website, social media and other traditional media interviews. The SEC charged the Manager for failing to register CAF as an investment company under the Investment Company Act of 1940, and with violations of registration requirements under and anti-fraud provisions of the Securities Act of 1933 (the “Securities Act”), as well as violations of the Investment Advisers Act of 1940 anti-fraud provisions. The Manager did not file a registration statement with the SEC and no exemption was available for the digital assets. The Matter of TokenLot LLC, Lenny Kugel and Eli L. Lewitt10 In a second order, the SEC found that TokenLot, LLC, a digital asset website platform and self-described “ICO Superstore” for investors of “all experience levels” facilitated the sale of various digital tokens through ICOs, as well as secondary market transactions of numerous digital tokens following their initial offering. In total, more than 6,100 9 In the Matter of Crypto Asset Management, LP and Timothy Enneking, Administrative Proceeding File No. 3-18740, SECURITIES AND EXCHANGE COMMISSION (Sept. 11, 2018). Available at https://www.sec.gov/litigation/admin/2018/33-10544.pdf. 10In the Matter of TokenLot LLC, Lenny Kugel and Eli L. Lewitt, Administrative Proceeding File No. 3-18739, SECURITIES AND EXCHANGE COMMISSION (Sept. 11, 2018). Available at https://www.sec.gov/litigation/admin/2018/33-10543.pdf. 11Department of Enforcement v. Timothy Tilton Ayre, Disciplinary Proceeding No. 2016049307801, FINANCIAL INDUSTRY REGULATORY AUTHORITY OFFICE OF HEARING OFFICERS (Sept. 11, 2018). Available at https://www.finra.org/sites/default/files/Ayre_Complaint_091118.pdf. 12United States of America v. Maksim Zaslavskiy, United States District Court Eastern District of New York, Memorandum and Order (Sept. 11, 2018). Available at https://www.scribd.com/document/388359656/zasl. 13The Howey Test refers to a 1946 U.S. Supreme Court case, SEC v. W.J. Howey Co., in which the Supreme Court created a test for determining whether certain transactions qualify as “investment contracts.” The Howey Test asks whether the value of a transaction for one of its participants is dependent upon the other's work. Specifically, the Howey Test determines that a transaction represents an investment contract if “a person invests his money in a common enterprise and is led to expect profits solely from the efforts of the promoter or a third party,” This test is now the longstanding test for what is and is not a “security.” individual investors placed more than 8,400 digital token purchase orders on the platform. The SEC concluded that certain of these digital tokens were securities and, thus, charged TokenLot, along with Kugel and Lewitt, its owners and operators, with violations of the Securities Exchange Act of 1934 (the “Exchange Act”) for illegally acting as an unregistered broker-dealer, as well as the Securities Act, for illegal sales of securities through interstate commerce without a registration statement or exemption. Neither Kugel nor Lewitt has ever held any securities licenses or been registered with the SEC in any capacity. FINRA disciplinary action11 In a separate disciplinary proceeding, also on September 11, FINRA charged Timothy Ayre, who at the time of the conduct was registered with a FINRA member broker-dealer but acting outside of that capacity, with violations of the Securities Act, the Exchange Act and FINRA rules in connection with the public offering and sale of unregistered cryptocurrency securities tied to Rocky Mountain Ayre, Inc. (“RMTN”), a public company of which Ayre was president and a director. Ayre marketed these crypto assets, called “HempCoin,” as the “first mintable coin backed by marketable securities.” By tying the rights to a certain amount of RMTN common stock to each HempCoin, Ayre transformed the former cryptocurrency into a security. FINRA also found that in addition to offering and selling unregistered securities, Ayre defrauded investors by authoring and publishing multiple disclosure documents and financial statements regarding RMTN that contained material false and misleading statements and omissions, as well as false assertions. EDNY finding12 Likewise, on September 11, the United States District Court for the Eastern District of New York (the “EDNY”) ruled that an action against a defendant, alleged to have engaged in a fraudulent offering of virtual securities related to two ICOs, could not be dismissed on the grounds that the digital tokens were not securities, but rather that the question of whether the tokens were securities was one that a jury would have to decide. The case, United States v. Zaslavskiy (“Zaslavskiy”), is one of the first to consider the applicability of federal securities laws in a criminal case involving digital securities or tokens. Zaslavskiy involves allegations, brought by the SEC, that Maksim Zaslavskiy, the owner of two companies, REcoin Group Foundation LLC and Diamond Reserve Club, fraudulently induced investors to purchase purported crypto “tokens” or “coins” promoted in connection with the planned ICOs of each of the companies. The defendant sought a dismissal, asserting that the tokens at issue in the case are not securities under the “Howey Test” 13 and that Section 10(b) and Rule 10b-5 of the Exchange Act are unconstitutionally vague as applied to the activities at issue. Judge Dearie denied the motion to dismiss in its entirety and stated that “stripped of the 21st-century jargon,” the government’s indictment “charges a straightforward scam, replete with the common characteristics of many financial frauds.” Although the court observed that, given that the case was before it in regards to the motion to dismiss, a determination on the question of whether the tokens are securities under the Howey Test was premature, the court nevertheless provided a detailed analysis of the investments under the Howey Test in coming to its conclusion that a reasonable jury could indeed conclude that such investments were securities. The court also concluded that the securities laws were not unconstitutionally vague as applied to this context. The motion to dismiss was thus denied. Shortfalls in the ICO Market Ever since the concept of smart contracts, the technology underlying ICOs, was first introduced, many of the proponents thereof have argued that code could be used to replace traditional institutions for safeguarding commitments and rights within transactional relationships. The proposed ideal is a “grand merger of law and computer security,” which might render the protections offered by the former superfluous.14 A July 2018 article15 published by the University of Pennsylvania School of Law sought to determine how well ICOs were fulfilling this ideal standard. Based on a review of “white papers” and other contract-like documents for the fifty topgrossing ICOs of 2017 (which raised over U.S.$2.6 billion), the research concluded that ICOs are falling short in terms of delivering on their contractual promises. The authors evaluated the study set of ICOs on the basis of three key investor protections:  First, did ICO promoters make any promises (and encode those assurances) to restrict the supply of their crypto assets?  Second, did ICO promoters pledge (and build their promises into smart contracts) to restrict the transfer of any crypto assets allocated to insiders according to a vesting or lock-up plan?  Third, did ICO promoters retain the power to modify the smart-contract code governing the tokens they sold, and if so, did they disclose that they had allocated themselves that power? Following their survey, which lined up disclosure against code, the researchers found that:  only about two in three of the surveyed ICOs coded for restriction of supply;  only about 80% of the sample made a promise to include vesting provisions, and of that 80%, less than a third used smart contracts to encode these rights; and  the vast majority of ICO disclosure did not address whether the tokens were modifiable, but one in six of those that were silent on the matter were in fact subject to modification. The authors suggest that these findings offer valuable lessons to legal scholars, economists and policymakers about the roles played by gatekeepers and the value of regulation in a relatively anonymous, decentralized environment. Summary Despite the idealistic aspirations of smart contract promoters and believers in the infallibility of code, it appears that we still have a ways to go in making sure the benefits of code can be utilized as described, and in the meantime, until the day where perhaps that ideal may be realized, regulation still seems necessary to fill the gap. Without a doubt, smart contracts present a great technological innovation, and ICOs are a novel and efficient way to raise capital, each with many benefits which we continue to explore and better understand. Yet cryptocurrency investors must bear in mind that they currently transact in unregulated markets where the traditional protections for investors are largely absent. The lack of market regulation leaves these investors exposed to volatile markets where a risk of complete loss is always present. The useful innovations that are associated with cryptocurrency and its related technologies should not be dismissed. However, despite the great possibilities, the key principle remains that our laws will seek to protect investors from dangerous or illegal financial practices or fraud, and to ensure the integrity of transactions. If you have any questions, please contact any of the people listed below, or your usual Linklaters contacts. 14Szabo, Nick, Formalizing and Securing Relationships on Public Networks, FIRST MONDAY (Sept. 1997). 15Cohney, Shaanan and Hoffman, David A. and Sklaroff, Jeremy and Wishnick, David A., supra, note 3. 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