A US 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 is 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. Purportedly REcoin was backed by real estate chosen by a team of experts, while Diamond was backed by diamonds. However, alleged the government, the defendant never developed the relevant cryptocurrencies, and investors purchasing REcoins, or exchanging REcoins for Diamond digital assets received no digital assets in return. Moreover, no cryptocurrencies created by Mr. Zaslavskiy were supported by any asset. (Click here to access a copy of the criminal complaint against Mr. Zaslavskiy.)

In ruling against the defendant, the court said that the government had alleged sufficient facts demonstrating that REcoin and Diamond were investment contracts under applicable legal precedent (i.e., (1) an investment of money, (2) in a common enterprise with (3) the expectation of profits solely from the efforts of a promoter or third party; click here to access the initial articulation of this standard in SEC v. WJ. Howey, a 1946 Supreme Court decision). However, the court noted that the fact-finder hearing Mr. Zaslavskiy’s trial would ultimately make the final decision regarding the nature of the purported cryptocurrencies based on facts presented at that time.

Prior to the criminal complaint being filed against Mr. Zaslavskiy, the Securities and Exchange Commission filed a civil complaint in the same federal court. (Click here for background in the article “SEC Files Lawsuit Against Companies and Backer for Purportedly Fake Initial Coin Offerings” in the October 1, 2017 edition of Bridging the Week.) This action was stayed pending resolution of the criminal case in January 2018.

Legal Weeds: This decision is a very important decision for both the Department of Justice and the Securities and Exchange Commission as it confirms the SEC’s position that crypto assets issued as part of ICOs could be securities if they satisfy the elements of an investment contract as set forth by the Supreme Court in Howey. This view was most prominently stated by the SEC in a Report of Investigation related to digital tokens offered and sold by DAO, an unincorporated virtual organization, during April and May 2016. (Click here for background in the article “SEC Declines to Prosecute Issuer of Digital Tokens That It Deems Securities Not Issued in Accordance with US Securities Laws” in the July 26, 2017 edition of Between Bridges.)

Just a few weeks ago, a different judge in the same federal district court in Brooklyn handed the Commodity Futures Trading Commission a similar affirmation of its own authority. There, in connection with an enforcement action by the CFTC against Cabbagetech Corp. and Patrick McDonnell, its owner and controller, the court entered an order of permanent injunction, imposed a civil penalty of approximately US $871,000, and ordered restitution of approximately US $290,000 against the defendants for unlawfully soliciting customers to send money and virtual currencies for virtual currency trading advice and for the discretionary trading of virtual currencies.

In ruling against the defendants, the federal court held that virtual currencies are commodities and that the CFTC had jurisdiction to bring its enforcement action relying on the fraud-based manipulation prohibition in the Dodd-Frank Wall Street Reform and Consumer Protection Act and a parallel CFTC rule. (Click here to access Commodity Exchange Act Section 6(c)(1), 7 U.S.C. § 9(1) and here for CFTC Rule 180.1)

(Click here for full details regarding the Cabbagetech decision in the article “Federal Court Enters Final Judgment Against Alleged Virtual Currency Fraudster; Confirms CFTC Authority to Bring Enforcement Action” in the August 26, 2018 edition of Bridging the Week.)

My View: Hopefully, the government’s initial victory in  Zaslavskiy will empower the SEC to thoughtfully engage with the industry to more precisely differentiate among cryptocurrencies that are not securities, digital assets that are likely securities and digital assets that principally serve a utility purpose, even if traded on secondary markets. William Hinman’s open reflection regarding ether and the characteristics of digital assets a few weeks ago was a good starting point but seems to have been somewhat undercut by Chairman Jay’s Clayton’s pronouncement last week that when staff speaks on topics, they only speak for themselves, not the SEC. (Click here for commentary elsewhere in this edition of Bridging the Week regarding this development. Mr. Hinman is the SEC's Director of the Division of Corporate Finance.)

The SEC and CFTC have long dealt with products that have characteristics of futures and securities – instrumentsknown as security futures – and have worked out rules for the exercise of their jurisdiction over such products. (Click here for general background.) Using this precedent as a basis, the SEC and CFTC should be able to carve out formal criteria for when a cryptocurrency is not a security.

Similarly, relying on its own precedent, the SEC should be able to provide more definitive guidance when a digital asset meant to be used exclusively on an associated blockchain for services or functionality is not a security token solely because it may trade on a secondary market. As divisions of the SEC have seemingly acknowledged on multiple occasions, just because something has some qualities of an investment contract – like a baseball stadium's seat leases – and trade on secondary markets – like eBay – doesn’t mean they should be regulated as securities. (Click here, e.g., for a request for no action by the San Francisco Baseball Associates L.P. related to seat leases and here for the grant of no-action relief by the Office of Chief Counsel of the Division of Corporate Finance on February 24, 2006.)

Beanie babies and original issue 2008 Tesla Roadsters are not securities solely because they trade on secondary markets and rise or fall in value because of the promotional activities of Ty Inc. and Elon Musk.