On November 16, 2018, the SEC instituted separate proceedings against CarrierEQ, Inc. (dba “AirFox”) and Paragon Coin Inc. (“Paragon”, and together with AirFox, the “Respondents”) through two cease-and-desist orders (the “AirFox Order[1]” and the “Paragon Order[2]” , respectively, and together, the “Enforcement Orders”). On the same day, the Division of Corporation Finance, Division of Investment Management, and Division of Trading and Markets of the SEC issued a joined statement (the “Joint Statement”), reiterating positions the SEC has held consistently for the past year on three key aspects of commercial activities related to digital assets, namely, primary offers and sales of digital assets, secondary market trading of digital assets, and investments in digital assets by pooled investment vehicles.

The AirFox Order and the Paragon Order are significant in that they are the first enforcement cases since the Munchee Order[3] against issuers of digital tokens solely for violations of the registration or exemption requirements of the federal securities law and without any allegation of fraud. Both AirFox and Paragon raised a considerable amount of funds to finance the development of their respective blockchain ecosystems through ICOs. Neither AirFox nor Paragon registered their ICOs pursuant to federal securities laws, nor did they seek to rely on an exemption from the registration requirement. The SEC applied the standard investment contract analysis derived from the Howey line of cases to reach its conclusion that the Respondents were in fact issuing investment securities through their ICOs and should therefore either have registered the offerings or relied on an exemption from the registration requirement.

The Joint Statement also made references to three prior enforcement orders issued by the SEC: (1) an order issued on November 8, 2018 (the “EtherDelta Order[4]” ), finding that respondent EtherDelta’s activities of bringing together buyers and sellers of digital asset securities clearly fell within the definition of a securities exchange, and the fact that EtherDelta used smart contract technology to carry out these activities did not change the nature of such activities; (2) an order issued on September 11, 2018 (the “TokenLot Order[5]” ), charging respondent TokenLot LLC, a platform for ICOs and secondary market trading of digital tokens, as well as its owners, with acting as unregistered broker-dealers; and (3) an order issued on September 11, 2018 (the “Crypto Asset Management Order[6]” ), finding that a fund formed to invest in digital assets is an investment company that should have been registered with the SEC. These orders, together with the prior Munchee Order and the DAO Report , make it clear that (i) the SEC’s position on the determination whether a digital asset is a security has been consistent since the DAO Report[7], and (ii) once a digital asset is determined to be a security, the ramifications will flow through all commercial activities relating to such digital asset, affecting not just the issuer of such digital asset, but also other market participants involved in the trading and investment in such digital asset.

Offer and Sale of Digital Assets

The Howey analysis performed in the AirFox Order and the Paragon Order provides little new insight into how the SEC determines whether a digital token constitutes a security because “bad facts” pervade the orders. At the time of their respective ICOs, neither AirFox nor Paragon had a fully functioning platform or blockchain ecosystem that permitted the tokens sold to be used immediately, thus providing ground for a finding that the purchasers were purchasing the tokens for speculative gains. Both AirFox and Paragon assured their purchasers at the time of their ICO that there would be secondary trading markets for the tokens shortly after the completion of the offering but prior to the launch of their blockchain ecosystem, thus incentivizing purchasers who were interested in the tokens only for their potential appreciation in value. AirFox’s promotions were also not directed at potential customers who would ultimately use the tokens in its blockchain ecosystem, but instead at digital token investors, some of whom received their allocations at a discounted price and thus stood to gain through resales on the secondary market. And finally, in their marketing efforts, both AirFox and Paragon promised purchasers that their respective management teams would improve the ecosystem and take other steps to cause the tokens to appreciate in value. These facts all lend themselves to satisfying the key prongs of the Howey test, i.e., a reasonable expectation of profits to be derived from the entrepreneurial or managerial efforts of others.

While both the AirFox tokens and the Paragon tokens were supposed to be “utility” tokens, with genuine utility functions within their respective blockchain ecosystems, here as in the SEC’s past enforcement actions on digital token issuers, such utility, by and in itself, was viewed as insufficient to overcome the many bad facts enumerated by the SEC that point toward purchasers’ potential profit motives. The utility argument has to work within the Howey test framework, i.e., having genuine utility by and in itself will not shield a digital token from an unfavorable finding; if, on the other hand, the relevant utility is such that it is highly unlikely that purchasers would be purchasing for any other reason than the utility of the token, then we may have a case of a non-security utility token. However, sifting through the SEC’s enforcement actions over the past year, it should be clear by now how difficult it would be to make such a case.

Trading of Digital Assets

The Joint Statement also provides guidance to market participants other than digital token issuers on what activities would have licensing requirements under federal securities law. The EtherDelta Order relates to the registration requirement as a national securities exchange, and the TokenLot Order is about the registration requirement as a broker-dealer. Both orders illustrate the approach of functional analysis in such determinations.

According to the EtherDelta Order, “any entity that provides a marketplace for bringing together buyers and sellers of securities, regardless of the applied technology, must determine whether its activities meet the definition of an exchange under the federal securities laws.” Thus, a threshold determination is whether buyers and sellers are trading securities on such a marketplace. Only after that will the functional test under Rule 3b-16 of the Securities Exchange Act of 1934 (the “Exchange Act”) come into play in making the determination whether the marketplace meets the definition of an exchange under Section 3(a)(1) of the Exchange Act. In the EtherDelta Order, the SEC found that (1) some of the tokens that were traded on EtherDelta were securities, and (2) EtherDelta provided a marketplace for buyers and sellers of such tokens/securities, and therefore concluded that EtherDelta was a securities exchange that was required to register with the SEC. The fact that the EtherDelta system utilized an innovative technology—smart contracts that run on the Ethereum blockchain—to conduct its business activities does not change the analysis.

Likewise, the SEC found in the TokenLot Order that TokenLot facilitated secondary market trading of digital assets that were securities, and therefore was acting as a broker-dealer. TokenLot was a self-described “ICO superstore” where investors could purchase digital assets during or after an ICO, including in private sales and pre-sales. Similar to the exchange analysis of the EtherDelta Order, the broker-dealer determination in the TokenLot Order also hinges on whether the digital assets being traded are securities. The SEC found that (1) some of the digital tokens that TokenLot dealt in were securities (though the SEC did not specify which ones were securities and why); (2) TokenLot’s activities included marketing and facilitating the sale of digital assets, accepting investors’ orders and funds for payment, and enabling the disbursement of proceeds to the issuers, which are functions performed by a broker; and (3) TokenLot also regularly purchased and then resold digital tokens for its own accounts, which activity falls under the definition of a dealer under the Exchange Act. As a result, TokenLot was determined to be required to register with the SEC under Section 15(a) of the Exchange Act and become a member of a self-regulatory organization such as FINRA.

Investments in Digital Assets by Pooled Investment Vehicles

Pooled investment vehicles formed for the purpose of making investments in digital assets, and investment advisers who advise clients on such investments may also fall under the SEC’s jurisdiction under the Investment Company Act of 1940 (the “Investment Company Act”) and the Investment Advisers Act of 1940 (the “Advisers Act”), respectively, if such digital assets are securities. The Crypto Asset Management Order demonstrates that. The SEC found that the crypto fund managed by the respondent Crypto Asset Management was a pooled investment vehicle formed for the purpose of investing in digital assets. Because more than 40 percent of the assets of the fund were digital assets that were securities, the fund should have been registered as an investment company under the Investment Company Act absent an available exemption from such registration requirement. Because of that determination, Crypto Asset Management, as manager to the fund, would also be subject to the SEC’s regulation as an investment adviser under the Advisers Act.

Key Takeaways

The Joint Statement and the enforcement orders mentioned therein make it clear that it is not just issuers of digital tokens who should worry about federal securities law violations. Other market participants who are involved in the trading and investment in digital assets also need to be mindful of the securities law implications for their business activities. If a digital asset is determined to be a security, there will be impacts on all activities subject to regulation under federal securities law.