The message from the SEC is very clear: participants in initial coin offerings (ICO’s) and cryptocurrencies in general need to comply with the federal securities laws or they will be the subject of enforcement proceedings. This message spreads beyond companies and entities issuing cryptocurrencies, also including securities lawyers, accountants, consultants and secondary trading platforms. Moreover, the SEC is not the only watchdog. State securities regulators and the plaintiffs’ bar are both taking aim at the crypto marketplace. Several class actions have been filed recently against companies that have completed ICO’s.
After a period of silence, on July 25, 2017, the SEC issued a Section 21(a) Report on an investigation and related activities by the DAO, with concurrent statements by both the Divisions of Corporation Finance and Enforcement. On the same day, the SEC issued an Investor Bulletin related to ICO’s. For more on the Section 21(a) Report, statements and investor bulletin, see HERE. Since that time, the SEC has engaged in a steady flow of enforcement proceedings and statements on the subject.
The DAO report centered on a traditional analysis to determine whether a token is a security and thus whether an ICO is a securities offering. In particular, the nature of a digital asset (“coin” or “token”) must be examined to determine if it meets the definition of a security using established principles, including the Howey Test. See HERE for a discussion on the Howey Test. The report also pointed out that participants in ICO’s are subject to federal securities laws to the same extent they are in other securities offerings, including broker-dealer registration requirements, and that securities exchanges providing for trading must register unless an exemption applies.
On November 1, 2017, the SEC issued a warning to the public about the improper marketing of certain ICO’s, token offerings and investments, including promotions and endorsements by celebrities. Celebrities, like any other promoter, are subject to the provisions of Section 17(b) of the Securities Act, including the requirement to disclose the nature, scope, and amount of compensation received in exchange for the promotion. For more on Section 17(b) and securities promotion in general, see HERE.
On December 11, 2017, SEC Chairman Jay Clayton issued a statement on cryptocurrencies and initial coin offerings. In that statement, Clayton drilled down on the sudden rise of “non-security” ICO’s, now being referred to as “utility tokens,” clearly conveying the message that if a token has attributes of a security, it will be governed as a security. To make the message even clearer, also on December 11, 2017, the SEC halted the ICO by Munchee, Inc., disagreeing with Munchee’s statements and conclusions that its token was a “utility token” and not a security.
This was not the first ICO halt. On December 4, 2017, the SEC halted the ICO by PlexCorps, including outright fraud with the claims of an unregistered offering. The SEC has also taken aim at companies that are in the crypto space in general, having halting the trading of The Crypto Company on December 19, 2017 after a 2,700% stock price increase. This was not the first trading halt, either. Others include American Security Resources Corp, halted on August 24, 2017; First Bitcoin Capital, halted on August 23, 2017; CIAO Group, halted on August 9, 2017; and Sunshine Capital on June 7, 2017.
More recently, on January 5, 2018, the SEC halted the trading of UBI Blockchain Internet, Ltd. citing questions regarding the accuracy of information in SEC filings and concerns about market activity, which was the epitome of an unexplained stock surge.
On August 28, 2017, the SEC issued an investor alert warning about public companies making ICO-related claims. The alert specifically mentioned the trading suspensions and warned that ICO claims could be a sign of a pump-and-dump scheme.
On January 4, 2018, Chair Clayton issued another statement, this time joined by Commissioners Kara Stein and Michael Piwowar, commenting on the North American Securities Administrators Association (NASAA) statement made the same day. The NASAA is a group comprised of state securities regulators, which, among other functions, acts as a communication arm for the individual state regulators on important marketplace topics.
Jay Clayton’s December 11, 2017 Statement
Jay Clayton begins his December 11, 2017 statement with an acknowledgement of the “tales of fortunes made and dreamed to be made,” which is a perfect description of ICO mania. Keeping with the SEC theme under Clayton, he then addresses ICO considerations for Main Street investors. In addition to warning of fraud and misrepresentations, ICO’s and cryptocurrency trading is a national marketplace; invested funds may quickly move overseas. Furthermore, the SEC may not be able to gain jurisdiction or pursue bad actors or lost funds in other countries.
The fact is that as of today, no cryptocurrency offerings have been registered with the SEC. Although Jay Clayton doesn’t talk about what registration will really mean for an ICO, I note that, since registration is the process of ferreting out disclosures, it will force an entity issuing an ICO to be clear about the usefulness of its token, if any, and the risk factors not only associated with its token, but the marketplace as a whole. My firm is currently working on registration statements as well as private offering documents for ICO’s and blockchain technology entities and the complexity of this new industry and technology, and uncertainty associated with legalities (including not only securities matters, but the implication of swap and commodity transactions, tax ramifications, intellectual property matters, etc.) is confounding to even the best and brightest.
The importance of the involvement and efforts by market professionals is not lost on the SEC. In the beginning, many ICO’s, believing that this new investment vehicle was somehow not a security and therefore outside the parameters of the securities laws and SEC jurisdiction, forewent the advice of legal counsel and other professionals. Now that this belief has been rectified, in his statement, Jay Clayton reminds market professionals of their gatekeeping duties. Chair Clayton states, “[I] urge market professionals, including securities lawyers, accountants and consultants, to read closely the investigative report we released earlier this year (the “21(a) Report”) and review our subsequent enforcement actions.”
He continues: “[F]ollowing the issuance of the 21(a) Report, certain market professionals have attempted to highlight utility characteristics of their proposed initial coin offerings in an effort to claim that their proposed tokens or coins are not securities. Many of these assertions appear to elevate form over substance. Merely calling a token a ‘utility’ token or structuring it to provide some utility does not prevent the token from being a security….. On this and other points where the application of expertise and judgment is expected, I believe that gatekeepers and others, including securities lawyers, accountants and consultants, need to focus on their responsibilities. I urge you to be guided by the principal motivation for our registration, offering process and disclosure requirements: investor protection and, in particular, the protection of our Main Street investors.” The bold emphasis was from the SEC, not added by me. The message could not be clearer.
Attorneys and other professionals are not the only groups that the SEC is taxing with gatekeeper responsibilities. Jay Clayton adds: “[I] also caution market participants against promoting or touting the offer and sale of coins without first determining whether the securities laws apply to those actions. Selling securities generally requires a license, and experience shows that excessive touting in thinly traded and volatile markets can be an indicator of ‘scalping,’ ‘pump and dump’ and other manipulations and frauds. Similarly, I also caution those who operate systems and platforms that effect or facilitate transactions in these products that they may be operating unregistered exchanges or broker-dealers that are in violation of the Securities Exchange Act of 1934.” Again, the bold emphasis is not mine. Although Jay Clayton does not indicate so, I am unaware of any properly licensed secondary market or exchange for the trading of cryptocurrencies at this time. TZero is properly licensed, but not up and functioning as of the date of this blog.
Jay Clayton’s statement is not all negative. He recognizes that ICO’s can be an effective method to raise capital and fund projects. He also recognizes that not all cryptocurrencies are securities. A specific example would be an in-app game with token purchases that can only be used to reach another level. However, Clayton points out that “[B]y and large, the structures of initial coin offerings that I have seen promoted involve the offer and sale of securities and directly implicate the securities registration requirements and other investor protection provisions of our federal securities laws.”
The Division of Enforcement has been instructed to vigorously police the ICO marketplace. Finally, the SEC encourages investors to conduct thorough due diligence before making an ICO investment. In that regard, he provides a list of basic questions that should be asked and considered before making any investment.
January 4, 2018 Statements by Chair Clayton and Commissioners Kara Stein and Michael Piwowar
On January 4, 2018, Chair Clayton, Commissioners Kara Stein and Michael Piwowar issued a statement commending the North American Securities Administrators Association’s (NASAA) own statement made the same day addressing concerns with ICO’s and cryptocurrencies. The NASAA is a group comprised of state securities regulators.
The SEC’s top brass specifically point out that cryptocurrencies are not, in fact, currencies in that they are not backed or regulated by sovereign governments and seem to be focused on a method of capital raising as opposed to mediums of exchange. Reiterating its other messaging, the SEC reminds the public that offerings and their participants must comply with the state and federal securities.
NASAA Statement on Cryptocurrencies and ICO’s
NASAA begins its statement with a consistent theme to the SEC, warning Main Street investors to be cautious about investments involving cryptocurrencies. NASAA, also like the SEC, encourages potential investors to conduct due diligence and ask questions before making an ICO (or any) investment.
NASAA includes a laundry list of risks and issues with ICO’s and crypto-related investments. NASAA points out that unlike FIAT or traditional currencies, cryptocurrencies have no physical form and typically are not backed by tangible assets (though I note that this is a void that is quickly being addressed by new tokens backed by physical assets and commodities).
Furthermore, cryptocurrencies are not insured, not controlled by a central bank or other governmental authority, are subject to very little if any regulation, and cannot be easily exchanged for other commodities. Cryptocurrencies are susceptible to breaches, hacking and other cybersecurity risks, including on both the ICO issuer side and the investor side through direct breaches into a wallet or other digital storage. ICO’s are a global investment vehicle and, as such, US regulators may have no ability to recover lost funds or pursue bad actors. Likewise, private civil proceedings could prove futile.
Moreover, the high volatility and high risk of cryptocurrency investments make them unsuitable for most investors. In both its statement and a very simple investor-directed animated video on the subject, NASAA clearly states that investors could lose all of their money in a crypto-related investment.
Regulators almost unanimously believe that cryptocurrencies involve a high risk of fraud. NASAA includes a list of obvious red flags, including guaranteed high returns, unsolicited offers, sounds too good to be true, pressure to buy immediately, and unlicensed sellers.
NASAA now lists ICO’s and cryptocurrency-related investment products as an emerging investor threat for 2018.
Further Reading on DLT/Blockchain and ICO’s
For a discussion on the Section 21(a) Report on the DAO investigation, statements by the Divisions of Corporation Finance and Enforcement related to the investigative report and the SEC’s Investor Bulletin on ICO’s, see HERE.
For a summary of SEC Chief Accountant Wesley R. Bricker’s statements on ICO’s and accounting implications, see HERE.
For an update on state distributed ledger technology and blockchain regulations, see HERE.