A federal court in California declined to impose a preliminary injunction against defendants accused by the Securities and Exchange Commission of engaging in a fraudulent and unlawful offer and sale of securities, stating that the SEC had not demonstrated that the cryptoassets purchased by investors were securities under applicable law.

The SEC had previously obtained a temporary restraining order against the defendants – Blockvest, LLC, and its chairman and founder, Reginald Buddy Ringgold, III a/k/a Rasool Abdul Rahim El – claiming that they engaged in fraud and the offer and sale of unregistered securities – cryptoassets called “BLV’s” – that initially were sold through presales to an initial coin offering and an ICO.

According to the SEC, the defendants falsely claimed that their ICO received regulatory approval from the SEC and that Blockvest had a relationship with Deloitte, a public accounting firm, when it did not, and made other material misrepresentations. The emergency order froze defendants’ assets and temporarily prohibited them from violating anti-fraud laws. (Click here for further background on the SEC’s TRO action in the article “ICO Claiming SEC Approval Halted by SEC” in the October 14, 2018 edition of Bridging the Week.)

In response to the SEC’s application for a preliminary injunction, the court noted that it could only grant such relief if the SEC demonstrated a “prima facie case” of a prior violation of federal securities laws and a “reasonable” likelihood of a repeat future violation. The court said the SEC satisfied neither of these elements.

The court held that the SEC did not show a prior securities law violation because, among other things, it did not demonstrate that the relevant cryptoassets were securities. This is because the SEC failed to demonstrate each of the three prongs of the so-called “Howey test” – necessary to evidence that an instrument is an investment contract (a type of security) – had been met: (1) an investment of money (2) in a common enterprise (3) with the expectation of profits accomplished through the efforts of others. (Click here to access the Supreme Court’s 1946 decision in SEC v. W.J. Howey Co.) The court concluded that the SEC provided “no evidence” to support that investors expected profits (i.e., capital appreciation derived from “the development of [their] initial investment”) or a sharing of earnings generated from the use of their invested funds.

Moreover, since defendants represented through counsel they would not without prior notice to the SEC engage in any ICO activities going forward, the SEC failed to demonstrate a reasonable likelihood that the wrong would be repeated.

In other legal developments involving cryptoassets:

  • Ohio Accepts Bitcoin for Taxes: Ohio authorized businesses operating in the state to pay state business taxes with bitcoin. To accommodate this, Ohio will use BitPay to process bitcoin payments on its behalf. Each transaction will be subject to a transaction and network fee assessed by BitPay, and a miner fee utilized to effectuate transactions on the bitcoin blockchain.
  • OFAC Targets Exchangers of Bitcoin Ransom Payments Acting for Purported Iranian Ransomware Orchestrators: The United States Department of Treasury’s Office of Financial Assets Control prohibited transactions with Ali Khorashadizadeh and Mohammad Ghorbaniyan for their role in helping exchange bitcoin ransomware payments into Iranian real for Iranian persons as part of the so-called “SamSam” ransom scheme. This scheme, which began in approximately December 2015 and continued through at least November 2018, involved use of malware to take over victims’ computers and required payment in a cryptocurrency such as bitcoin to restore the victims’ control. As part of its prohibition, OFAC published the digital currency addresses of Mr. Khorashadizadeh and Mr. Ghorbaniyan; this marked the first time that OFAC has identified digital currency addresses for specially designated persons.

Relatedly, during the last two weeks, the US Department of Justice filed charges against two Iranian nationals – Faramarz Shahi Savandi and Mohammad Mehdi Shah Mansouri – for engaging in the SamSam ransom scheme (click here to access the relevant indictment) and the Department of Treasury issued additional guidance on how to apply OFAC sanctions’ programs in connection with transactions involving cryptocurrencies (click here to access relevant Questions and Answers).

  • LabCFTC Tries to Smarten Public Regarding Smart Contracts: The Commodity Futures Trading Commission’s LabCFTC issued a primer on smart contract technology, describing its purpose and functionality, and noting some relevant operational and regulatory risks. (Generally, a smart contract references self-executing software code often associated with a blockchain that automatically causes actions to occur between parties based on preprogrammed conditions being met without the involvement of a central authority.) The CFTC noted that, despite the autonomous operation of smart contracts, “[e]xisting law and regulation apply equally regardless of what form a contract takes.”

CFTC Commissioner Brian Quintenz recently warned that all products and transactions within the Commission’s jurisdiction are subject to the Commission’s regulation even if they are executed on a blockchain utilizing autonomous smart contracts. If there are violations of laws or regulations, it may be challenging to identify who is responsible, he said, but someone is.

Shortly afterwards, the SEC brought and settled charges against Zachary Coburn for enabling EtherDelta, an online platform that allows persons to buy and sell cryptoassets, many of which have the attributes of securities, to operate as an exchange for securities in interstate commerce without registering as a national securities exchange or operating pursuant to a lawful exemption. EtherDelta relied on smart contract technology for its exchange operation (Click here for background in the article “Autonomous Doesn't Necessarily Mean Non-Regulated Says SEC in Fining Founder of Securities Cryptoasset Exchange Powered By Automated Smart Contract” in the November 11, 2018 edition of Bridging the Week.)

  • CEO of Decentralized Banking Platform Indicted and Arrested for Purported Fraudulent Conduct: Jared Rice, Sr., the chief executive officer and co-founder of AriseBank, was indicted in a federal court in Texas and arrested for his role in connection with an alleged cybersecurity fraud engaged in by the purported bank from at least June 2017 through January 2018. The indictment claimed that, during the time, Mr. Rice defrauded “hundreds of investors” of approximately US $4.25 million.

Earlier this year, the SEC filed civil charges against AriseBank, Mr. Rice, and Stanley Ford, the other co-founder of AriseBank, in connection with AriseBank’s allegedly fraudulent ICO. The SEC charged that AriseBank’s ICO constituted the unlawful offer of securities without registration or a qualified exemption. The SEC also charged that AriseBank committed fraud in its solicitations by falsely claiming that a new subsidiary of the firm was an FDIC-insured bank and that it was able to offer an AriseBank-branded VISA card, and by not disclosing the criminal background of Mr. Rice who, at the time, was on probation for felony theft. If convicted, Mr. Rice could serve up to 120 years’ imprisonment.

  • Boxer and Singer Rapped by SEC for Promoting ICOs Without Disclosing Personal Compensation Arrangements: Two celebrities, Floyd Mayweather, Jr. and Khaled Khaled, were named in SEC enforcement actions for publicly endorsing ICOs of cryptocurrencies that the Commission claimed were securities without disclosing they were paid for their endorsements as required by law (click here to access Section 17(b) of the Securities Act of 1933, 15 U.S.C. § 77q(b)). Mr. Mayweather agreed pay over $610,000, including a fine and disgorgement, to resolve his SEC matter, while Mr. Khaled agreed to remit over US $150,000.
  • Singapore Exchange Sets Obligations for Listed Companies’ ICOs: The Singapore Exchange set forth requirements for listed companies that desire to engage in initial coin offerings where the cryptoassets would not be listed on SGX. Among other things, SGX expects relevant issuers to consult with SGX prior to the ICO, provide it a legal opinion as to the nature of the cryptoassets to be issued, and keep its shareholders informed of material information related to the ICO. If the instruments are of the nature of securities or capital markets products under Singapore law, other requirements would also apply. However, said SGX, the Monetary Authority of Singapore views cryptoassets that can be used to purchase goods and services and have no additional associated rights as not necessarily being required to be regulated as securities.

Legal Weeds/My View: During September 2018, a federal court in Brooklyn, New York, declined to dismiss a criminal indictment against Maksim Zaslavskiy charging him with securities fraud and related offenses in connection with two cryptocurrency investment schemes and their related initial coin offerings.

Mr. Zaslavskiy had argued that the indictment should be dismissed because his activities did not involve securities and that the relevant law prohibiting fraud in connection with the offer and sale of securities was unconstitutionally vague. The court rejected Mr. Zaslavskiy’s arguments, saying that, at least for the basis of the defendant’s motion to dismiss, the government had sufficiently alleged that the relevant digital assets were securities and that the relevant law prohibiting fraud was not unconstitutionally vague as applied in his case.

The government initially charged that Mr. Zaslavskiy, through two companies he founded – REcoin Group Foundation, LLC and DRC Work, Inc. (known as Diamond Reserve Club) – offered investors an opportunity to obtain new cryptocurrencies – REcoin and Diamond – through an ICO and an “initial membership offering,” respectively. The court ruled that the government had alleged sufficient facts demonstrating that REcoin and Diamond were investment contracts under the Howey test. (Click here for background in the article “Brooklyn Federal Court Rules ICO-Issued Digital Assets Could Be Securities” in the September 16, 2018 edition of Bridging the Week.)

Mr. Zaslavskiy pleaded guilty to securities fraud in connection with these ICOs in November 2018. (Click here for details in the article “Defendant Pleads Guilty to Securities Fraud in Connection with Two Initial Coin Offerings” in the November 18, 2018 edition of Bridging the Week.)

The different outcomes between the Blockvest and Zaslavskiy cases – although resting on different preliminary presentations of facts – may herald an ultimate determination by a higher court as to what the expectation of profits accomplished through the efforts of others prong of the Howey test actually means. Although the Department of Justice and SEC have repeatedly argued that cryptoassets issued as part of presales to ICOs and ICOs are most often securities, investors in such digital assets do not typically expect to share any income from the project identified with the ICO and the value of their cryptoassets only remotely, if at all, is tied to the value of such projects. Moreover, investors in digital assets will likely have no claims on the assets of a project if the project goes bankrupt.

Investments in digital assets are very different from the investments in orange groves managed by the promoters of the investments at issue in Howey. It has always seemed to me that cryptoassets that the DOJ and the SEC claim are investment contracts are, in many cases, more like collectibles traded among enthusiasts than securities.