The Department of Justice opposed the February 27 motion of Maksim Zaslavskiy to dismiss the criminal indictment that had been filed against him in November 2017, charging that he engaged in illegal unregistered securities offerings and securities fraud in connection with the initial coin offerings of two digital tokens (REcoin and DRC) organized by two of his companies, REcoin Group Foundation, LLC and DRC World, Inc. The complaint was filed in a federal court in Brooklyn, New York. The Securities and Exchange Commission supported the DoJ’s opposition motion.

Among other things, Mr. Zaslavskiy claimed in his motion that the digital tokens he tried to create were not securities but cryptocurrencies, and that all currencies, fiat and otherwise, are not securities under applicable law. (Click here for background on Mr. Zaslavskiy’s motion in the article “Federal Court, Treasury and SEC Provide Further Guidance on Cryptocurrencies; Subject of Criminal Complaint for ICO Asks Court to Dismiss Prosecution Claiming Cryptocurrencies Are Not Securities” in the March 11, 2018 edition of Bridging the Week.)

The DoJ argued that the REcoin and DRC ICOs were securities because they were “prototypical” investment contracts. According to the DoJ, applying the landmark Supreme Court decision in SEC v. W.J. Howey Co. (click here to access), each ICO was an investment contact because it represented “an investment of money in a common enterprise with a reasonable expectation of profits to be derived solely from the entrepreneurial or managerial efforts of others.” According to the DoJ, it was irrelevant that no dividends were to be paid to investors; rather, both REcoin and DRC tokens were sold as investments that would increase in value because of the managerial efforts of Mr. Zaslavskiy, and this potential appreciation would be equivalent to a pro rata distribution satisfying the Howey requirement that investors expect profits as a result of their investment.

Although it conceded that currencies are excluded from the definition of currencies, the DoJ said that REcoin and DRC tokens were not currencies solely because they were marketed as cryptocurrencies. Indeed, observed the DoJ, “[t]he superficial resemblance in its label is the only similarity between REcoin/[DRC] and currency.” In its view, currencies under applicable law are only legal tender or something equivalent, “like a cash substitute.”

The SEC generally restated the DoJ’s arguments, although in its supporting brief, it articulated unique challenges ICOs have posed law enforcement agencies in investigating fraud. These challenges include, among other things, the lack of involvement of traditional financial institutions making tracing funds more difficult; the international nature of the blockchain making obtaining and using information from foreign jurisdictions more difficult; a lack of central authority in blockchains forcing the SEC to rely on other sources for information; freezing assets in encrypted wallets is difficult; and the pseudonymous or anonymous nature of the blockchain making it difficult or impossible to identify the attribution of specific digital assets.

Separately,

  • The US Taxman Cometh – for Cryptocurrency Income: The US Internal Revenue Service reminded taxpayers that income from virtual currencies transactions must be reported on their income tax returns and are taxable. The IRS regards virtual currency as property for federal tax purposes. Payments made using virtual currency are subject to information reporting as are other payments made in property (click here for details);
  • G20 Recognizes Potential Cryptocurrency Usefulness: The G20 meeting in Argentina last week acknowledged that “technological innovation,” including underlying crypto-assets, has the potential to enhance the “efficiency and inclusiveness” of the financial system, as well as the economy generally, despite issues crypto-assets have raised regarding consumer and investor protection, market integrity and money laundering. Accordingly, the G20 recommended that regulatory bodies continue to monitor crypto-assets and their risks to consider “multilateral responses as needed” (click here for details);
  • FTC Brings Bitcoin-Related Fraud Lawsuit: The Federal Trade Commission obtained a temporary restraining order against four individuals who the agency alleged operated a pyramid scheme involving the purchase of Bitcoin. The FTC alleged in a complaint that the defendants engaged in deceptive acts by misrepresenting to investors that the referral pyramid scheme they marketed could earn substantial income. The FTC seeks a permanent injunction against the defendants, as well as disgorgement, restitution and other relief. The agency brought its case in a federal court in Florida and named as defendants: Scott Chandler, Thomas Dluca, Louis Gatto, and Eric Pinkston (click here to access details);
  • HK Regulator Halts ICO: Black Cell Technology halted an ICO to the Hong Kong public following regulatory intervention by the Hong Kong Securities and Futures Commission. Black Cell had said it would use proceeds from its ICO to fund a mobile application. The SFC claimed that Black Cell’s ICO constituted the unlawful sale of a collective investment scheme without proper authorization or licensing, or a valid exemption (click here to access details);
  • Toronto Stock Exchange to Establish Crypto-Asset Brokerage Service: The Toronto Stock Exchange announced that Shorcan Digital Currency, its wholly owned subsidiary, along with Paycase Financial, would, during the second quarter of 2018, launch a new cryptocurrency brokerage service focusing on Bitcoin and Ether and create cryptocurrency benchmarks from data from cryptocurrency exchanges worldwide (click here to access details); and
  • US Bans Venezuela Virtual Currency: President Donald Trump issued an Executive Order banning access by US persons to a digital token issued by the Venezuelan government. The digital token, known as the “Petro” and supposedly backed by commodities, including oil, was introduced to help Venezuela avoid international sanctions (click here for a copy of the Executive Order).
  • OFAC Warns Prohibited Persons Using Virtual Currencies Are Still Prohibited Persons: The Office of Foreign Assets Control of the US Department of Treasury indicated in an update to its Frequently Asked Questions related to sanctions compliance, that persons subject to its jurisdiction are prohibited from doing business with persons named on OFAC's Specially Designated Nationals and Blocked Persons list, whether utilizing fiat or virtual currency. OFAC indicated that it may add digital currency addresses to its SDN List to alert the public of specific digital currency identifiers associated with blocked persons. OFAC said that persons that identify digital currency identifiers or addresses associated with prohibited persons "should take the necessary steps to block the relevant digital currency and file a report with OFAC that includes information about the wallet or address's ownership, and any other relevant details." (Click here to access OFAC's revised Q&As, 559 - 563.)

Legal Weeds and My View: Although it seems clear that the SEC views most, if not all, ICO-issued tokens to constitute securities, as I have argued before, this analysis seems to overextend the facts and conclusion of Howey, and make so many unlikely things securities.

In Howey, investors purchased land sales contracts and service contracts in connection with orange groves to derive income from the oranges’ harvest and sale by the promoters. This was not a scheme to gain appreciation in the land’s value through resale.

In connection with the sale of REcoin and DRC tokens, investors were only to obtain “profits” through appreciation in the value of their investments. There was no expectation of receipt of dividends or other indicia of income. Thus the reasonable expectation of profits solely through the efforts of others was attenuated at best. This is because very rarely is the price of any cryptocurrency solely (let alone principally) a function of the value of the project underlying the relevant digital token. Although the market perception of the value of a project is, in part, very much relevant to the price of a digital token (i.e., the network effect), so is the price of Bitcoin and other crypto-assets generally, the potential impact of regulation, market and media hype, the perceived utility of a token and the innovation of a token in advancing distributed ledger technology evolution.

Additionally, the SEC’s view of what constitutes an investment contact would make many collectible objects that are hyped by their developers or promoters, including collectible cars and private gold coins, securities. Although there is some precedent for this view (click here to access Marini v. Adamo, a 2014 court decision from a Brooklyn federal court holding in dictum that there was a “factual basis” to find rare coins securities even if this basis had not been stipulated by the parties), it seems a stretch. Very few, if any, owners of 2008 Tesla Roadsters believe they are driving a security.

No malefactor should be able to escape appropriate punishment and/or sanctions because gaps in law are cleverly exploited. It is critical that the SEC, the Commodity Futures Trading Commission and other regulators proactively consider how cryptocurrencies fit within existing laws and legal precedent to not impede beneficial applications of decentralized ledger technology while ensuring customer protection and market integrity. To the extent law must be amended to rationalize regulation and plug gaps, this should be done sooner not later, and in a thoughtful manner that allocates responsibilities among regulators based on specific criteria that define virtual securities, virtual currencies and other crypto-assets.