In a speech last week before the Securities Regulation Institute, Securities and Exchange Commission Chairman Jay Clayton cautioned lawyers who may not be instructing clients that digital tokens issued as part of initial coin offerings are securities and subject to possible registration requirements, when the digital tokens are “likely” securities under applicable law standards. According to Mr. Clayton, such lawyers provide their clients “it depends” advice, when there is little doubt regarding the nature of the product offered during an ICO. In response, Mr. Clayton warned he has instructed SEC personnel “to be on high alert for approaches to ICOs that may be contrary to the spirit of our securities laws and the professional obligations of the U.S. securities bar.”
Mr. Clayton additionally noted that the SEC would be "looking closely" at public companies that change their name to reference the blockchain – such as to "Blockchain-R-Us" – when the company has no demonstrable track record of utilizing the blockchain for business purposes. Mr. Clayton indicated that the SEC would be looking at such companies' public disclosures to see if such firms are complying with applicable securities laws.
Separately, Mr. Clayton and J. Christopher Giancarlo, Chairman of the Commodity Futures Trading Commission, penned an Opinion published in The Wall Street Journal on January 24, where they acknowledged that a “key issue” they are reflecting upon is “whether our historical approach to the regulation of currency-transactions is appropriate for the cryptocurrency markets.” As a result, said the two chairpersons, “[w]e would support policy efforts to revisit these frameworks and ensure they are effective for the digital era.”
Currently, in the US, the SEC has broad oversight over all securities and securities markets, while the CFTC does not have direct authority over exchanges that transact in virtual currencies, unless the facilities offer trading in swaps or futures involving such products, or financing to retail clients in connection with their purchases of virtual currencies that do not result in actual delivery within 28 days. Exchanges or persons holding virtual currencies are likely subject to requirements by the Financial Enforcement Network of the Department of Treasury, and money transmitter obligations or other requirements by many states. (Click here for a broad overview of the US regulatory environment involving cryptocurrencies in the CFTC’s January 4, 2018 “Backgrounder on Oversight and Approach to Virtual Currency Futures.”)
In other unrelated material developments involving cryptocurrencies:
- Cboe BZX Withdraws Requests to Trade Bitcoin ETFs: Cboe BZX Exchange, Inc. withdrew a number of pending proposed rule changes filed with the Securities and Exchange Commission in December 2017 to list exchange-traded funds that principally intended to trade Bitcoin futures. (Click here for a sample withdrawal notice.) This follows issuance two weeks ago of a letter by the SEC’s Division of Investment Management to two industry organizations indicating that no SEC registered funds were likely to be approved for trading virtual currencies or virtual currency futures contracts until questions regarding custody, liquidity and potential manipulation were satisfactorily answered. (Click here for further details in the article “SEC Not Feeling Groovy About Cryptocurrencies – Tells Registered Investment Funds: Slow Down, You Move Too Fast” in the January 22, 2018 edition of Bridging the Week.)
- Korean Regulator Imposes New Requirements on Banks for Cryptocurrency Exchange Transactions: The Korean Financial Services Commission imposed new requirements on banks facilitating trading on cryptocurrency exchanges in Korea. Under the new requirements, users who engage in cryptocurrency transactions must have a bank account in their real name at the same bank where the cryptocurrency exchange they utilize maintains an account. Moreover, banks must apply enhanced due diligence in evaluating transactions with cryptocurrency exchanges and the exchanges must provide users’ identification information to their banks, upon request. (Click here for a copy of the FSC announcement.) Additionally, eight Korean cryptocurrency exchanges were fined by the Korean Communications Commission for not complying with data protection requirements for their users and required to meet their obligations within 30 days (click here for background).
Legal Weeds: On July 25, 2017 the SEC published a Report of Investigation concluding that digital tokens issued by an entity for the purpose of raising funds for projects – even if using distributed ledger or blockchain technology – may be securities under federal law. If so, such securities must be registered with the Commission or eligible for an exemption from registration requirements. Moreover, the SEC concluded that any person offering trading facilities like an exchange for digital tokens that are securities must be registered as a national securities exchange or be exempt from such registration requirement. (Click here to access the Commission’s Report.)
The SEC’s Report followed an investigation by the SEC’s Division of Enforcement which concluded that digital tokens offered and sold during April and May 2016 by DAO, an unincorporated virtual organization created by Slock.it UG, a German corporation, were securities subject to the SEC’s registration requirements. According to the SEC, investors purchased DAO tokens through transactions on the Ethereum Blockchain in exchange for approximately 12 million Ether (“ETH,” a virtual currency) that was valued at approximately US $150 million at the time.
The SEC based its conclusion that the DAO tokens were securities on the four-part test articulated in a landmark 1946 US Supreme Court decision, SEC v. W.J. Howey (click here to access). There, the Supreme Court ruled that a security includes an “investment contract” and an investment contract constitutes an (1) investment of money (2) in a common enterprise (3) with a reasonable expectation of profits (4) to be derived solely from the entrepreneurial or managerial efforts of others. Applying this test to the DAO entity and DAO tokens, the SEC concluded that purchasers of DAO tokens (1) invested money in the form of ETH (2) to invest in a common enterprise, the DAO entity, (3) with an expectation of profits from projects. Moreover, the Commission concluded (4) that since the profits of the DAO enterprise would be derived significantly from the managerial efforts of Slock.it, its co‑founders and the DAO’s curators, the fourth prong of the Howey test was also satisfied. A few years prior to Howey, the US Supreme Court in SEC v. C.M. Joiner Leasing Corp. (click here to access), indicated that, in assessing whether an investment in oil leases constituted a security, investors' expectation of profits could be satisfied by the expected capital appreciation of their investment through the development efforts of others – not only by their anticipated receipt of earnings.
More recently, the SEC filed and simultaneously resolved an enforcement proceeding against Munchee Inc., for conducting an initial digital coin offering of "MUN" digital tokens that it claimed constituted the unregistered offer or sale of securities. Munchee agreed to cease and desist from its violations to settle this matter. Although Munchee in its "White Paper" described the utility benefits of possessing MUNs in promotional materials and other marketing efforts (e.g., the more MUNs a person held, the more MUNs it would receive for writing restaurant reviews), the principal benefit of holding MUNs was the potential for appreciation of their value through Munchee’s entrepreneurial efforts. As a result, concluded the SEC, MUN tokens were securities and Munchee’s offer and sale of MUN tokens without filing a registration statement with it (absent a bona fide exemption) was illegal. (Click here for further details in the article “Non-Registered Cryptocurrency Based on Munchee Food App Fails to Satisfy SEC’s Appetite for Non-Security” in the December 17, 2017 edition of Bridging the Week.)