Why it matters: On June 17, 2015, the SEC announced that it had reached a settlement with Sand Hill Exchange to resolve charges that it had illegally offered and sold unregistered security-based swap contracts to ineligible retail investors through a form of "fantasy investing" league. The same day, the SEC's Office of Investor Education and Advocacy issued an Investor Alert warning investors to "Beware of Fantasy Stock Trading Websites Offering Real Returns."

Detailed discussion: On June 17, 2015, the SEC announced that it had reached a settlement with San Mateo, California-based unincorporated business Sand Hill Exchange (Sand Hill) and the two individuals who jointly ran it, Gerrit Hall (Hall) and Elaine Ou (Ou), to resolve charges that they had sold unregistered security-based swaps to retail investors who did not meet mandated "eligibility requirements" in violation of the Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010 (Dodd-Frank). As part of the settlement, and without admitting or denying the SEC's findings, Sand Hill, Hall and Ou agreed to cease and desist their activities and pay the SEC a civil monetary penalty of $20,000. The SEC acknowledged the cooperation of Sand Hill, Hall and Ou in the investigation.

The findings contained in the Order filed simultaneously with the SEC's press release show that Hall and Ou started Sand Hill in August 2014 with the intent to "create a business that would involve valuing private start-up companies," with a special focus on companies operating in Silicon Valley, California. Over the next seven months, Hall and Ou experimented with several "fantasy investment" business models that were variations of "fantasy sports" leagues where "trading" involved valuations of private start-up companies using "credits" issued by Sand Hill. However, starting around mid-February 2015, Hall and Ou began inviting users to "trade" contracts using real money. The findings show that Hall and Ou "fully" understood that they were "buying and selling derivatives linked to the value of private companies" and that they intended to pay users who profited from the contracts they purchased. Under the new business model, "users funded their Sand Hill accounts with either dollars or Bitcoins and then bought and sold contracts that would allow them to profit (or suffer losses) in the future." Hall sent emails to Sand Hill users on February 13, 2015, announcing the new business model and stating "[i]f you ever wanted to profit off an early stage startup, now's your chance. Here's how it works: We list great startups, from seed stage to pre-IPO; You can buy/sell smart contracts on the expected value of the company at liquidation; You can close your position at any time, or hold on until the company exits." One example of a contract that users were able to buy involved the payment of one dollar for every $1 billion of the company's valuation at the time of an IPO or other "liquidity event." The findings show that Hall and Ou did not ask users about their financial holdings or seek to limit Sand Hill to users with a specific threshold of assets, stating on their website that "[w]e accept everybody regardless of accreditation status." The findings also show that, in order to attract users, Hall and Ou routinely exaggerated or outright lied about Sand Hill's trading accomplishments, backing, and legal, auditing, and regulatory approval undertakings on the website, in emails and in Twitter posts.

Ultimately, the findings show that 83 individuals "traded" 2,300 contracts with an aggregate value of $10,000, which provided Sand Hill profits of about $5,400 in dollars and Bitcoins. On March 10, 2015, the Financial Times published an article on its blog about Sand Hill and, two days later on March 12, Hall and Ou received their first inquiry from the SEC. Thereafter, Hall and Ou only accepted money from five new users and cooperated with the SEC's investigation, which the SEC credited as "limiting the scope of their violations." By April 8, 2015, Hall and Ou had ceased Sand Hill operations altogether and refunded all deposits to users.

The SEC found that the Sand Hill contracts were derivative "security-based swaps" regulated by Dodd-Frank because their "payouts were linked to the valuation of private companies at a liquidity event" in the future, such as a merger, initial public offering or dissolution. Sand Hill, Hall and Ou were found to have offered and sold the security-based swap contracts in violation of Dodd-Frank because they were issued without a registration statement or backing of a national exchange to individuals who were not "eligible contract participants," defined in the statute to include individuals who meet stated "sophistication" standards such as monetary thresholds invested (e.g., at least $5-$10 million invested in the market on a discretionary basis).

Also on June 17, 2015, as a "companion piece" to its press release, the SEC's Office of Investor Education and Advocacy issued an Investor Alert warning investors to "Beware of Fantasy Stock Trading Websites Offering Real Returns," which stated its purpose was to "warn investors about fantasy stock trading and other similar websites that may violate federal securities laws designed to protect investors from abuses in the swaps market." The Alert began with the statement that "[y]ou may come across websites that claim to offer you the chance to make money from publicly traded or privately held companies without actually buying stock in those companies. You (as well as the operators of these sites) should be aware that some of these transactions could fall under a type of security known as a 'security-based swap.' Transactions on these websites can implicate both the federal securities and commodities laws. Even when the site presents the transaction as a 'fantasy' trading game or competition, and even when it involves only small amounts of money (sometimes called an 'entry fee'), you should understand these sites may be violating laws designed to protect investors." (Emphasis in original.) The Alert helpfully describes security-based swaps and states that the SEC is in the process of implementing a new regulatory regime for them. The Alert also informs investors that, in order to "trade" these swaps, they need to qualify as "eligible contract participants," which the Alert goes on to define. Last, the Alert highlights the types of "pay-to-play 'fantasy' trading competitions" investors should look out for, and specifically references the SEC's enforcement action against Sand Hill, Hall and Ou.

In its June 17 press release, the SEC emphasized that this is only the beginning of the investigation into these "fantasy trading" sites and their ilk: "The Complex Financial Instruments Unit will continue its scrutiny of the retail market for conduct that may violate the Dodd-Frank Act's swaps provisions, including online competitions creatively monetizing what actually constitute security-based swaps transactions."

See here to read the SEC's 6/17/15 press release titled "SEC Announces Enforcement Action for Illegal Offering of Security-Based Swaps."

See here to read the SEC's Order dated 6/17/15 titled "In the matter of Sand Hill Exchange, Gerrit Hall and Elaine Ou."

See here to read the Investor Alert issued by the SEC's Office of Investor Education and Advocacy titled "Beware of Fantasy Stock Trading Websites Offering Real Returns."