On March 27, 2018, the top securities regulator in Massachusetts issued consent orders halting five initial coin offerings — including projects that sought to raise capital to assist families affected with cancer and to support the programming for children — based on allegations that the token sales constituted unregistered securities offerings in violation of state law.1 Among other things, a number of the companies behind the ICOs, each of which were either incorporated or primarily did business in the state, agreed to refund investors as a condition of settlement. The consent orders come on the heels of increased federal scrutiny of ICOs by the U.S. Securities and Exchange Commission and the U.S. Commodity Futures Trading Commission, and serve as a reminder that market participants in the virtual currency space must be mindful of state regulators as well.
The recent regulatory activity in Massachusetts was foreshadowed by remarks that the secretary of the commonwealth, William Galvin, made in December 2017. First, on Dec. 13, Galvin commented that “Bitcoin is just the latest in a history of speculative bubbles that most often burst, leaving the average investors with a worthless product.”2 He warned investors to consider the volatility and risk posed by virtual currencies before making any investment decisions, and cautioned that the “unregulated and ambiguous nature of Bitcoin provides a fertile ground for investment scams and other financial fraud.”.3 Two days later, on Dec. 15, 2017, Galvin stated that his office would undertake “‘aggressive policing’” of ICOs, which it perceives “as a form of a security investment that should be regulated.’”4 Later that month, Galvin referred to the bitcoin market as “entirely speculation” that “doesn’t pass the smell test.”.5
The commonwealth brought its first ICO-related enforcement action in January 2018. Specifically, Galvin’s office filed an administrative complaint against Caviar, a company that was incorporated in the Cayman Islands but primarily operated out of Massachusetts, and its majority partner, Kirrill Bensonoff, “for offering the sale of a security without such security being registered or exempt from registration.” The complaint alleges that the offered digital tokens fall under the definition of securities under state law because they contemplate financial returns from the investment and thus fall within the catch-all category of securities known as investment contracts.6 According to the complaint, investors were told that “proceeds from the ICO w[ould] be pooled and used to finance the acquisition of a portfolio of various cryptocurrencies, and to finance short term ‘flips’ of residential real estate properties” that would yield quarterly dividends.7 The requested relief included, among other things, censure, a cease-and-desist order, disgorgement, rescission and an administrative fine.8
The latest wave of ICO-related activity by Galvin’s office follows a similar pattern, targeting ICOs that touted the possibility of financial gain and allegedly bore the hallmarks of a security. This “ICO cryptocurrency sweep” is likely only the tip of the iceberg for ICOs in Massachusetts.9 Moreover, other states may well follow suit. For example, following Galvin’s December warning about the dangers of virtual currency investments, Florida, North Carolina and Kansas issued investor alerts relating to initial coin offerings. Texas has also become an active regulator of virtual currency activity: Between December 2017 and February 2018, the Texas State Securities Board issued five emergency cease-and-desist orders to respondents engaged in various forms of virtual currency activity, including issuing unregistered securities to Texas residents or to unaccredited investors10 and making misrepresentations related to cryptocurrency ventures.11
Other Virtual Currency Regulatory Activity
The recent enforcement activity in Massachusetts and Texas is an example of how states are using existing statutory principles and rules to regulate virtual currency ventures. But states have also enacted specific legislation and rules relating to the regulation of virtual currency. For example, Washington has included virtual currency in the definition of “money transmission” under state law, requiring certain businesses that transact in virtual currency to obtain a license to do business in the state. New York similarly requires businesses that engage in “virtual currency transmission” — defined as the “[s]toring, holding, or maintaining custody or control of virtual currency on behalf of others; [b]uying and selling virtual currency as a customer business; [p]erforming exchange services as a customer business; [or] [c]ontrolling, administering, or issuing a virtual currency” — to obtain an operating license.
Such initiatives were intended to provide clarity and guidance to the burgeoning virtual currency industry. To a large extent, however, licensing requirements have proved to be unduly burdensome in practice, with many companies stating that they would have to discontinue their virtual currency service offerings in states like Washington and New York to avoid the expense and hassle. Moreover, to the extent that states have different licensing requirements and application fees, virtual currency businesses face a substantial barrier to entry in the national market. In this context, some market participants have called for uniformity in how states treat virtual currency businesses to encourage continued growth and innovation.
The Uniform Law Commission — an organization that was founded to “provide states with non-partisan, well-conceived and well-drafted legislation that brings clarity and stability to critical areas of state statutory law”12 — has drafted a uniform virtual currency act, titled the Uniform Regulation of Virtual-Currency Businesses Act. Among other things, this act sets forth the scope of state oversight over virtual currency, clarifying who or what may be regulated, and imposes licensing and operational requirements on businesses engaged in certain activity relating to virtual currency.13 The act was approved by the National Conference of Commissioners on Uniform State Laws and recommended for enactment in all the states on July 19, 2017.14 It has since been introduced and is pending approval by the legislatures in Connecticut, Nebraska and Hawaii.15
Whether or not additional states will follow suit and implement the act remains to be seen. One thing is certain however: As the virtual currency industry continues to grow, states will continue to exercise increased oversight over its activities in one form or another. Market participants should remain aware of their exposure to both federal and state regulatory bodies.