The original virtual currency, Bitcoin, started in 2009 as a private form of currency to use in lieu of fiat currency (such as the US dollar or the euro) for online transactions. Largely due to its wide price volatility--in 2017 the price of Bitcoin soared from $1,000 to almost $20,000 then back to $12,600, and in the first quarter of 2018 the price declined by almost 50%-- Bitcoin’s role as a medium of exchange has diminished while its use in capital formation and trading has increased. For years, the Securities and Exchange Commission (SEC) was cautious in its approach to virtual currencies, but given an environment where virtual currencies may be offered and sold like securities, the SEC has been compelled to take action. The SEC has voiced its approval of efforts by state securities regulators and industry groups like the National Association of Securities Administrators (NASAA) to implement coordinated crackdowns on fraud in the virtual currency arena, such as “Operation Cryptosweep” announced May 21, 2018.
The SEC’s Mission and Jurisdiction. The proclaimed mission of the SEC is to protect investors, maintain fair, orderly, and efficient markets, and facilitate capital formation. For the scope of this article, the SEC’s primary areas of regulatory enforcement deal with (i) offerings and sales of securities, (ii) fraud or misleading disclosure involving securities and (iii) regulation of exchanges on which securities are traded. The SEC does not have direct oversight of transactions in currencies or commodities. The determinative question for the SEC is whether, in a particular situation, a virtual currency is a “security”, i.e., whether it involves an investment of money or value in a business or operation where the investor has a reasonable expectation of profits based upon the efforts of others.
The SEC Looks at ICOs. An Initial Coin Offering (ICO) is a fundraising activity whereby new ventures sell a “coin” (often referred to as a “token”) often in exchange for virtual currency (like Ether) and in some cases fiat currency as well. A token offering may resemble a traditional offering of securities, depending on how the tokens are structured and marketed and what rights the tokens represent. Some ICOs are offered to limited numbers of accredited investors in “private placements” that are exempt from SEC registration requirements, while others are offered publicly.
- Utility Tokens? Several public offerings have tried to structure as a “token generation event” rather than ICO, and offer a “utility token”. By having the token give the purchaser future access or rights to the company’s products or services rather than an equity investment in the company itself, it was thought that the instrument and transaction may not be subject to securities laws (and SEC oversight). In a March 7, 2018 “spotlight” announcement, the SEC staff outlined several concerns about ICOs, and articulated a substance-over-form review: “ICOs, or more specifically tokens, can be called a variety of names, but merely calling a token a ’utility’ token or structuring it to provide some utility does not prevent the token from being a security.”
- ICO Registration. To date, no ICO has been registered and declared effective by the SEC as an offering of securities, although on March 6, 2018 a registration statement was filed for a $75 million ICO by The Praetorian Group. A cursory review of this registration statement reveals that it will likely need substantial amendment to comply with SEC rules and disclosure expectations. A formal review of an ICO registration statement should help articulate the SEC’s view on ICOs as public securities offerings and provide needed guidance in this area.
SEC Actions on ICOs. The SEC has taken multiple actions against parties involved in ICOs. In particular, the SEC has:
- Held that an initial coin offering (ICO) of tokens in a virtual company (known as The DAO) involved the offer and sale of securities subject to SEC regulation (July 25, 2017)
- Issued fraud charges against two ICOs purportedly backed by real estate and diamonds (September 29, 2017)
- Issued a statement on potentially unlawful promotion of ICOs by celebrities (November 1, 2017) and halted such an ICO on fraud charges (April 2, 2018)
- Obtained an emergency asset freeze to halt an ICO offering (December 4, 2017)
- Halted an ICO for a blockchain-based food review service, as constituting an unregistered offering and sale of securities (December 11, 2017)
- Issued a statement on cryptocurrencies and ICOs outlining considerations for investors and market professionals (December 11, 2017)
- Warned securities lawyers about providing equivocal advice or taking no position as to whether coins or tokens offered or sold (e.g., in ICOs) are securities subject to SEC registration (January 23, 2018)
- Charged fraud and appointed a receiver for an ICO for a “decentralized bank” that used social media and celebrity endorsements (January 30, 2018)
- Cautioned investors and market participants about “the three ‘Rs’ of ICOs: Risks, Rewards and Responsibilities” and reiterated concerns about unregistered securities offerings, unregulated exchanges, movement of funds outside of the US and inability to pursue bad actors and recover funds (March 7, 2018).
In addition, there have been recent press reports that the SEC has issued dozens of subpoenas and information requests to companies involved in ICOs, requesting information about the structure for sales and pre-sales of the ICOs. On May 16, 2018, the SEC launched a mock ICO website (HoweyCoins.com) to educate investors about the types of deception and fraud that may exist in hotly marketed ICOs.
Registration of ETFs? In December 2017, the Commodity Futures Trading Commission (CFTC) cleared trading of Bitcoin futures through the CBOE Futures Exchange and The CME Group, and several new Bitcoin ETF applications were quickly filed to capitalize on this development. In January 2018, the SEC staff requested the withdrawal of several of those applications, however, citing concerns about liquidity and valuation. The SEC Chair later elaborated concerns about custody of the fund holdings and creation, redemption and arbitrage issues in the ETF market. On March 23, 2018, the SEC announced its consideration (and request for public comments) on a rule change to allow NYSE Arca to list two Bitcoin futures ETFs, so the matter is far from closed.
Trading Platforms or “Exchanges”. There is a multitude of trading platforms or exchanges for virtual currencies. Many of them (such as BTCChina and Bitstamp) are located overseas, while others (like Coinbase and Cryptsy) are based in the United States.
- Regulation by FinCEN as Money Transmitters. For years, virtual currency exchanges and administrators have been viewed as money-transmission services subject to the Bank Secrecy Act and oversight by the Financial Crimes Enforcement Network (FinCEN)---and at the state level---rather than the SEC. On March 6, 2018, FinCEN published its position that “an exchange that sells ICO coins or tokens, or exchanges them for other virtual currency, fiat currency, or other value that substitutes for currency, would typically…be a money transmitter.” As a money transmitter, a virtual currency exchange is subject to the Bank Secrecy Act’s requirements for registration, collection of customer information, and anti-money laundering (AML) and combating the financing of terrorism (CFT) regulations. FinCEN noted that ICOs may be structured and traded in a variety of ways, which could involve the authority of the SEC (which regulates brokers and dealers in securities) or the CFTC (which regulates merchants and brokers in commodities), in which cases the AML/CFT requirements imposed by the SEC or CFTC would apply. FinCEN further noted that it is coordinating with the SEC and CFTC to “clarify and enforce” the AML/CFT obligations of businesses involved in ICOs.
- Registration of Exchanges with the SEC. In wide-ranging testimony to the US Senate Committee on Banking, Housing, and Urban Affairs on February 6, 2018, SEC Chairman Clayton summarized the SEC’s actions regarding virtual currencies and indicated that he was open to exploring whether increased federal regulation of virtual currency trading platforms is appropriate. In particular, he identified several gaps in the regulatory scheme such as:
- Investors not understanding that virtual currency exchanges do not offer the same protections as a SEC-registered exchange, such as best execution, regulation of front running and short sales, and custody and capital requirements; and
- The need to develop and coordinate regulation of domestic and foreign exchanges to avoid regulatory arbitrage.
On March 7, 2018, the SEC Divisions of Enforcement and Trading and Markets issued a “Statement on Potentially Unlawful Online Platforms for Trading Digital Assets,” where they reminded that “if a platform offers trading of digital assets that are securities and operates as an ‘exchange,’ as defined by the federal securities laws, then the platform must register with the SEC as a national securities exchange or be exempt from registration.” Under the Securities Exchange Act of 1934, an “exchange” is broadly defined to include “a market place or facilities for bringing together purchasers and sellers of securities or for otherwise performing with respect to securities the functions commonly performed by a stock exchange”. As with the SEC’s jurisdiction over ICOs, its regulation of virtual currency exchanges is dependent upon whether securities are involved.
Looking Forward. The SEC’s increasing focus on virtual currencies and ICOs will likely bring more oversight, guidance and enforcement in the coming months.