Tag: SEC

The CFTC And Cryptocurrencies

Posted on by Laura Anthony, Esq.

The SEC and U.S. Commodity Futures Trading Commission (CFTC) have been actively policing the crypto or virtual currency space. Both regulators have filed multiple enforcement actions against companies and individuals for improper activities including fraud. On January 25, 2018, SEC Chairman Jay Clayton and CFTC Chairman J. Christopher Giancarlo published a joint op-ed piece in the Wall Street Journal on the topic.

Backing up a little, on October 17, 2017, the LabCFTC office of the CFTC published “A CFTC Primer on Virtual Currencies” in which it defines virtual currencies and outlines the uses and risks of virtual currencies and the role of the CFTC. The CFTC first found that Bitcoin and other virtual currencies are properly defined as commodities in 2015. Accordingly, the CFTC has regulatory oversight over futures, options, and derivatives contracts on virtual currencies and has oversight to pursue claims of fraud or manipulation involving a virtual currency traded in interstate commerce. Beyond instances of fraud or manipulation, the CFTC generally does not oversee “spot” or cash market exchanges and transactions involving virtual currencies that do not utilize margin, leverage or financing. Rather, these “exchanges” are regulated as payment processors or money transmitters under state law.

The role of the CFTC is substantially similar to the SEC with a mission to “foster open, transparent, competitive and financially sound markets” and to “protect market users and their funds, consumers and the public from fraud, manipulation and abusive practices related to derivatives and other products subject to the Commodity Exchange Act (CEA).” The definition of a commodity under the CEA is as broad as the definition of a security under the Securities Act of 1933, including a physical commodity such as an agricultural product, a currency or interest rate or “all services, rights and interests in which the contracts for future delivery are presently or in the future dealt in” (i.e., futures, options and derivatives contracts).

Where the SEC regulates securities and securities markets, the CFTC does the same for commodities and commodity markets. At times the jurisdiction of the two regulators overlaps, such as related to swap transactions (see HERE). Furthermore, while there are no SEC licensed securities exchanges which trade virtual currencies or any tokens, there are several commodities exchanges that trade virtual currency products such as swaps and options, including the TeraExchange, North American Derivatives Exchange and LedgerX.

The Commodity Exchange Act would prohibit the trading of a virtual currency future, option or swap on a platform or facility not licensed by the CFTC. Moreover, the National Futures Association (NFA) is now requiring member commodity pool operators (CPO’s) and commodity trading advisors (CTA’s) to immediately notify the NFA if they operate a pool or manage an account that engaged in a transaction involving a virtual currency or virtual currency derivative.

The CFTC refers to the IRS’s definition of a “virtual currency” and in particular:

A virtual currency is a digital representation of value that functions as a medium of exchange, a unit of account, and/or a store of value. In some environments it operates like real currency but it does not have legal tender status in the U.S. Virtual currency that has an equivalent value in real currency, or that acts as a substitute for real currency, is referred to as a convertible virtual currency.  Bitcoin is one example of a convertible virtual currency.

I note that neither the CFTC’s definition of Bitcoin as a commodity, nor the IRS’s definition of a virtual currency, conflicts with the SEC’s position that most cryptocurrencies and initial cryptocurrency offerings today are securities requiring compliance with the federal securities laws. The SEC’s position is based on an analysis of the current market for ICO’s and the issuance of “coins” or “tokens” for capital raising transactions and as speculative investment contracts. In fact, a cryptocurrency which today may be an investment contract (security) can morph into a commodity (currency) or other type of digital asset. For example, an offering of XYZ token for the purpose of raising capital to build a software or blockchain platform or community where XYZ token can be used as a currency would rightfully be considered a securities offering that needs to comply with the federal securities laws. However, when the XYZ token is issued and can be used as a form of currency, it would become a commodity. Furthermore, the bundling of a token securities offering to include options or futures contracts may implicate both SEC and CFTC compliance requirements.

The CFTC primer gives a little background on Bitcoin, which was created in 2008 by a person or group using the pseudonym “Satoshi Nakamoto” as an electric payment system based on cryptographic proof allowing any two parties to transact directly without the need for a trusted third party, such as a bank or credit card company. Bitcoin is partially anonymous, with individuals being identified by an alphanumeric address. Bitcoin runs on a blockchain-decentralized network of computers and uses open-source software and “miners” to validate transactions through solving complex algorithmic mathematical equations.

A virtual currency can be used as a store of value; however, virtual currencies are not a yield asset in that they do not generate dividends or interest. Virtual currencies can generally be traded with resulting capital gains or losses. The CFTC, like all regulators, points out the significant speculation and volatility risk. The CFTC reiterates the large incidents of fraud involving crypto marketplaces. Furthermore, there is a significant cybersecurity risk. If a “wallet” holding cryptosecurities is hacked, they are likely gone without a chance of recovery.

Although many virtual currencies, including Bitcoin, market themselves as a payment method, the ability to utilize Bitcoin and other virtual currencies for everyday goods and services has not yet come to fruition. In fact, the trend toward Bitcoin being a regularly accepted payment has seemed to have gone the other way, with payment processor Stripe, tech giant Microsoft and gaming platform Steam discontinuing Bitcoin support due to lengthy transaction times and increased transaction failure rates.

Further Reading on DLT/Blockchain and ICO’s

For an introduction on distributed ledger technology, including a summary of FINRA’s Report on Distributed Ledger Technology and Implication of Blockchain for the Securities Industry, see HERE.

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.

For a summary of the SEC and NASAA statements on ICO’s and updates on enforcement proceedings as of January 2018, see HERE.

To read about the SEC and CFTC joint statements and the Wall Street Journal op-ed article, see HERE.

Inquiries of a technical nature are always encouraged. Contact us now.

The SEC And CFTC Joint Statements On Cryptocurrencies; Global Regulators Join In

Posted on by Laura Anthony, Esq.

On January 19, 2018 and again on January 25, 2018, the SEC and CFTC divisions of enforcement issued joint statements regarding cryptocurrencies. The January 19 statement was short and to the point, reading in total:

“When market participants engage in fraud under the guise of offering digital instruments – whether characterized as virtual currencies, coins, tokens, or the like – the SEC and the CFTC will look beyond form, examine the substance of the activity and prosecute violations of the federal securities and commodities laws. The Divisions of Enforcement for the SEC and CFTC will continue to address violations and bring actions to stop and prevent fraud in the offer and sale of digital instruments.”

The January 25, 2018 statement was issued by SEC Chairman Jay Clayton and CFTC Chairman J. Christopher Giancarlo and was published as an op-ed piece in the Wall Street Journal.  In summarizing the statements, I add my usual commentary and facts and information on this fast-moving marketplace.

Distributed ledger technology, or DLT, is the advancement that underpins an array of new financial products, including cryptocurrencies and digital payment services. Clearly the regulators understand the technological disruption, pointing out that “[S]ome have even compared it [DLT] to productivity-driving innovations such as the steam engine and personal computer.”

The regulators are careful not to discourage the technological advancement or investments themselves but rather are concerned that only those that are sophisticated and can afford a loss, participate. Likewise, unfortunately with every boom comes fraudsters, and investors have to ask the right questions and perform the right due diligence.

Like the dot-com era, of the hundreds (or thousands) of companies popping up in this space, few will survive and investments in those that do not, will be lost. The message from the regulators remains consistent, cautioning investors about the high risks with investments in this new space and stating that “[T]he CFTC and SEC, along with other federal and state regulators and criminal authorities, will continue to work together to bring transparency and integrity to these markets and, importantly, to deter and prosecute fraud and abuse.”

While the initial cryptocurrencies, like bitcoin and ether, were likened to a payment alternative to fiat currencies like the dollar and euro, these alternative currencies are very different.  None are backed by a sovereign government, and they lack governance standards, accountability and oversight, reliable reporting of trading, or consistent reporting of price and other financial metrics.

Of course, this is an exciting era of development and Chairs Clayton and Giancarlo know that, stating:

“This is not a statement against investments in innovation. The willingness to pursue the commercialization of innovation is one of America’s great strengths. Together Americans embrace new technology and contribute resources to developing it. Through great human effort and competition, strong companies emerge. Some of the dot-com survivors are the among the world’s leading companies today. This longstanding, uniquely American characteristic is the envy of the world. Our regulatory efforts should embrace it.”

The SEC and CFTC are considering whether the historic approach to the regulation of currency transactions is appropriate for the cryptocurrency markets. Check cashing, payment processing and money transmission services are primarily state regulated. Many of the Internet-based cryptocurrency trading platforms have registered as payment services and are not subject to direct oversight by the SEC or the CFTC. For example, Coinbase has money transmitting licenses from the majority of states. Gemini is a licensed trust company with the New York State of Financial Services. Furthermore, the Bank Secrecy Act and its anti-money laundering (AML) requirements apply to those in the business of accepting and transmitting, selling or storing cryptocurrencies.

Not a single cyptocurrency trading platform is currently registered by the SEC or CFTC.  However, two CFTC regulated exchanges have now listed bitcoin futures products and, in doing so, engaged in lengthy conversations with the CFTC, ultimately agreeing to implement risk mitigation and oversight measures, heightened margin requirements, and added information sharing agreements with the underlying bitcoin trading platforms. In my next blog I will drill down on the CFTC’s regulatory role and position on cryptocurrencies including a discussion of its October 17, 2017 published article, “A CFTC Primer on Virtual Currencies.”

The SEC does not have jurisdiction over transactions involving currencies or commodities; however, where an offering of a cryptocurrency has characteristics of a securities offering, the SEC and state securities regulators have, and have exercised, jurisdiction. In addition to the many SEC enforcement proceedings I have written about, state regulators have likewise been very active in the enforcement arena against those offering cryptocurrency- or blockchain-related investments. The SEC is carefully monitoring the entire marketplace including issuers, broker-dealers, investment advisors and trading platforms.  On January 18, 2018, the SEC issued a no-action letter prohibiting the registration under the Investment Company Act of 1940 of U.S. investment funds that desire to invest substantially in cryptocurrency and related products. I will provide further details on this letter in an upcoming blog.

As the boom has continued, many cryptocurrencies are simply being marketed for their potential increase in value on secondary trading platforms, again none of which are licensed by the SEC or CFTC.  The utility side of the tokens (if any) has taken a back seat to the craze.  Although a few trading platforms are licensed by state regulators as payment processors, many overseas are not licensed by any regulator whatsoever.

As the SEC has been repeating, the op-ed piece again clearly states that “federal securities laws apply regardless of whether the offered security—a purposefully broad and flexible term—is labeled a  ‘coin’ or ‘utility token’ rather than a stock, bond or investment contract. Market participants, including lawyers, trading venues and financial services firms, should be aware that we are disturbed by many examples of form being elevated over substance, with form-based arguments depriving investors of mandatory protections.”

While attending the North American Bitcoin Conference in Miami a few weeks ago, I was amazed at the thousands of attendees and companies. I go to a lot of financial conferences and had never seen anything like this. I understand the concerns of the regulators and the need to issue constant warnings. While I met some extremely smart people and learned about great companies that could have hugely successful futures, many others were obviously trying to ride a boom, with nothing to offer. They lacked a strong management team, technological know-how, engineers and programmers, a real business, a real plan, or anything to support lasting value of the token issued in their ICO, or being touted for a future issuance. The sole opportunity for an investor was a potential increase in secondary trading value, which was being propped up with hundreds of thousands of dollars (raised in the ICO) of marketing, including crews of people paid to talk about the token on chat boards such as Telegram.

Like many practitioners, I am fascinated with the technology and disruption it will bring to many aspects of our lives including the arenas of corporate finance and trading markets, and have even invested.

International Organization of Securities Commissions Issues Warning on ICO’s

On January 18, 2018, the Board of the International Organization of Securities Commissions (“IOSCO”) issued a warning on ICO’s including the high risk associated with these speculative investments and concerns about fraud. The IOSCO is the leading international policy forum for securities regulators and is a recognized standard setter for securities regulation. The group’s members regulate more than 95% of the world’s securities markets in more than 115 jurisdictions.

The statement from IOSCO points out that ICO’s are not standardized and their legal and regulatory status depends on a facts and circumstances analysis. ICO’s are highly speculative and there is a chance that an entire investment will be lost. The warning continues:

“[W]hile some operators are providing legitimate investment opportunities to fund projects or businesses, the increased targeting of ICOs to retail investors through online distribution channels by parties often located outside an investor’s home jurisdiction — which may not be subject to regulation or may be operating illegally in violation of existing laws — raises investor protection concerns.”

The IOSCO has provided its members with information on approaches to ICO’s and related due diligence. The IOSCO has also established an ICO Consultation Network with its members to continue the discussion.

Further Reading on DLT/Blockchain and ICO’s

For an introduction on distributed ledger technology, including a summary of FINRA’s Report on Distributed Ledger Technology and Implication of Blockchain for the Securities Industry, see HERE.

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.

For a summary of the SEC and NASAA statements on ICO’s and updates on enforcement proceedings as of January 2018, see HERE.

Inquiries of a technical nature are always encouraged. Contact us now.

SEC Statements On Cybersecurity – Part 2

Posted on by Laura Anthony, Esq.

On September 20, 2017, SEC Chair Jay Clayton issued a statement on cybersecurity that included the astonishing revelation that the SEC Edgar system had been hacked in 2016. Since the original statement, the SEC has confirmed that personal information on at least two individuals was obtained in the incident. Following Jay Clayton’s initial statement, on September 25, 2017, the SEC announced two new cyber-based enforcement initiatives targeting the protection of retail investors, including protection related to distributed ledger technology (DLT) and initial coin or cryptocurrency offerings (ICO’s).

The issue of cybersecurity is at the forefront for the SEC, and Jay Clayton is asking the House Committee on Financial Services to increase the SEC’s budget by $100 million to enhance the SEC’s cybersecurity efforts.

This is the second in a two-part blog series summarizing Jay Clayton’s statement, the SEC EDGAR hackingand the new initiatives. Part I of this blog, which outlined Chair Clayton’s statement on cybersecurity and the EDGAR hacking, can be read HERE . This second part in the series discusses the new cyber-based enforcement initiatives.

Previously I issued a blog outlining SEC guidance on the disclosure of cybersecurity matters, which can be read HERE.

Enforcement Initiatives

The SEC has established two new cybersecurity-related enforcement initiatives to address cyber-based threats and protect retail investors. The first is a creation of a Cyber Unit that will focus on targeting cyber-related misconduct. The second is the formation of a retail strategy task force that will focus on issues that directly affect retail investors.

Cyber Unit

The Cyber Unit will focus on:

  • Market manipulation schemes involving false information spread through electronic and social media
  • Hacking to obtain material nonpublic information in order to trade in advance of some announcement or event, or to manipulate the market for a particular security or group of securities
  • Violations involving distributed ledger technology (blockchain) and initial coin offerings (ICO’s)
  • Misconduct perpetrated using the dark web
  • Intrusions into retail brokerage accounts to conduct manipulative trading
  • Cyber-related threats to trading platforms and other critical market infrastructure

Chair Clayton formed the group with the goal of creating a cybersecurity working group to coordinate information sharing, risk monitoring, and incident response efforts throughout the agency. The Enforcement Division of the SEC has had to fast-track its expertise on matters related to cybersecurity including the advanced technologies that can be utilized.  It is thought that this focused enforcement initiative will further the SEC’s abilities to detect, respond to, and pursue misconduct.

On October 26, 2017, Stephanie Avakian, Co-Director of the Division of Enforcement gave a speech where she addressed both initiatives.   She addressed the obvious need for the Cyber Unit in today’s world of ever increasing cyber-related misconduct affecting the securities markets.

Expanding on the SEC’s list of areas of attention, Ms. Avakian indicates that the Cyber-Unit will also focus on cases involving failures by registered entities to take appropriate steps to safeguard information or ensure system integrity. The Cyber-Unit will work closely with the Office of Compliance, Inspections and Examinations (OCIE) in this area.

Further, the Cyber-Unit will review cases involving the failure by publicly reporting entities to properly report and disclose cyber related issues. The SEC has not yet brought a case in this space, but is expected to do so. The SEC expects companies’ to report cyber issues in risk factors and management discussion and analysis where appropriate and believes that the failure to do so could rise to a fraud issue under Rule 10b-5.

Retail Strategy Task Force

The Retail Strategy Task Force is planning to develop targeted initiatives to identify and pursue misconduct impacting retail investors.  The retail investor arena is a broad playing field including everything from the sales of unsuitable structured products to micro-cap pump-and-dump schemes. The Task Force will rely heavily on technology and analytics to identify problems. The Task Force includes enforcement personnel from around the country.

In her October 26, 2017 speech, Enforcement Co-Director, Stephanie Avakian stated, “this group will look at the many ways that retail investors intersect with the securities markets and look for widespread misconduct.” In a time of tight budgets, the SEC is focused on thinking strategically to identify problems and find the most efficient way to pursue enforcement actions including, as mentioned, with technology. Data analytics can be used to identify data by groups such as by product, by investor type, by location, by sales or trading practice, or by fee.  The SEC is even figuring out ways to use technology and data analytics to analyze the more than 16,000 tips it receives each year and integrate that data with other data points to identify issues.

Ms. Avakian gave specific examples of areas that the Retail Strategy Task Force will examine beyond the obvious Ponzi schemes and offering fraud, including:

  • Investment professionals steering customers to mutual fund share classes with higher fees, when lower-fee share classes of the same fund are available.
  • Abuses in wrap-fee accounts, including failing to disclose the additional costs of “trading away” or trading through unaffiliated brokers, and purchasing alternative products that generate additional fees.
  • Investors buying and holding products like inverse exchange-traded funds (ETFs) for long-term investment. These can be highly volatile products that are generally intended as a hedge against exposure to downward moving markets, and that face a long-term high risk of losing their principal. The SEC is increasingly seeing retail investors holding these products long-term, including in retirement accounts.
  • Problems in the sale of structured products to retail investors, including a failure to fully and clearly disclose fees, mark-ups, and other factors that can negatively impact returns; and
  • Abusive practices like churning and excessive trading that generate large commissions at the expense of the investor.

In addition to enforcement, the Retail Strategy Task Force will have an investor outreach and education component. In that regard, we can expect to see Investor Bulletins and other SEC investor communications generated from the Task Force’s findings and efforts.

SEC Issues Report on Initial Coin Offerings (ICOs)

Posted on by Laura Anthony, Esq.

On July 25, 2017, the SEC issued a report on an investigation related to an initial coin offering (ICO) by the DAO and statements by the Divisions of Corporation Finance and Enforcement related to the investigative report (the “Report”). On the same day, the SEC issued an Investor Bulletin related to ICO’s. Offers and sales of digital coins, cryptocurrencies or tokens using distributed ledger technology (DLT) or blockchain have become widely known as ICO’s. For an introduction on DLT and blockchain, see HERE.

The basis of the report is that offers and sales of digital assets, including cryptocurrencies, are subject to the federal (and state) securities laws. From the highest level, the nature of a digital asset must be examined to determine if it meets the definition of a security using established principles (see HERE). In addition, all offers and sales of securities must either be registered with the SEC or there must be an available exemption from such registration. This statement applies to cryptocurrency securities in the same manner it applies to all other securities. In addition, 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. Securities exchanges providing for trading must register unless an exemption applies.

Despite the SEC findings, it declined to pursue an enforcement action but rather used the opportunity to inform the public on its views and, in particular, that “the federal securities laws apply to those who offer and sell securities in the United States, regardless whether the issuing entity is a traditional company or a decentralized autonomous organization, regardless whether those securities are purchased using U.S. dollars or virtual currencies, and regardless whether they are distributed in certificated form or through distributed ledger technology.”

In the press release announcing the investigative findings, SEC Chair Jay Clayton stated, “[T]he SEC is studying the effects of distributed ledger and other innovative technologies and encourages market participants to engage with us. We seek to foster innovative and beneficial ways to raise capital, while ensuring – first and foremost – that investors and our markets are protected.”

This is not the first time the SEC has addressed registration and exemption requirements associated with cryptocurrencies. There have been several other cases. For example, in December 2014 the SEC settled charges against BTC Virtual Stock Exchange and LTC Global Virtual Stock Exchange related to violations of both the broker-dealer registration requirements and the securities offer and sale registration requirements. For more information on that case, see HERE.

This blog will summarize the SEC Report of Investigation, statements by the Divisions of Corporation Finance and Enforcement and the Investor Bulletin on Initial Coin Offerings.

SEC Report of Investigation on an ICO

On July 25, 2017, the SEC issued its Report on an investigation into an ICO and related activities by the DAO, an unincorporated entity, Slock.it UG (“Slock.it”), a German corporation, and various principals and participants. As mentioned earlier, although the report provides a platform for which the SEC can educate the marketplace, it did not pursue enforcement actions against the targets of the investigation.

The “DAO” stands for a decentralized autonomous organization, or a virtual network embodied in computer code on a on a DLT or blockchain. The DAO was created by Slock.it to sell tokens to investors, which proceeds would be used to fund for-profit projects. The token holders would share in the profits and, as such, had an expectation of a return on investment. The DAO tokens were also transferable and available for secondary trading on different web-based platforms.  After the ICO, but before projects were funded, the DAO was hacked and approximately one-third of its assets stolen. Fortunately the DAO was able to come up with a plan that caused the return of ETGH raised from the DAO back to their original Ethereum address and thus return investments to the original investors.

The SEC opened an investigation as to whether the offer and sale of the DAO Tokens invoked federal securities laws, whether the DAO Tokens were securities and whether the platforms for the secondary trading of the Tokens required registration as a securities exchange.  The answer to each of these questions, under the facts and circumstances presented, was in the affirmative. Since the DAO had not yet commenced operations, the SEC did not review whether the DAO was acting as an “investment company” under the Investment Company Act of 1940, but noted that had they begun operations, such an analysis would have been appropriate.

The Report begins with the conclusion.  Whether or not a particular transaction involves the offer and sale of a security depends on an analysis of the facts and circumstances, regardless of terminology or technology used or employed. All persons or entities that use a Decentralized Autonomous Organization (DAO Entity), DLT or other blockchain-based technology as a means to raise capital in the U.S. are subject to the U.S. federal securities laws. All securities offered and sold in the U.S. must be registered or must qualify for an exemption from registration. Moreover, any entities or platforms that allow for the secondary trading of securities must either be registered as a national securities exchange or operate pursuant to a registration exemption. The automation of functions, computer code, smart contracts, and decentralization does not change the obligations under the federal securities laws.

Background and Facts

In a one-month period from April 30, 2016, through May 28, 2016, the DAO offered and sold 1.15 billion DAO Tokens in exchange for 12 million Ether (“ETH”) valued at approximately $150 million USD. ETH is a virtual currency. The Financial Action Task Force defines a “virtual currency” as:

a digital representation of value that can be digitally traded and functions as: (1) a medium of exchange; and/or (2) a unit of account; and/or (3) a store of value, but does not have legal tender status (i.e., when tendered to a creditor, is a valid and legal offer of payment) in any jurisdiction. It is not issued or guaranteed by any jurisdiction, and fulfils the above functions only by agreement within the community of users of the virtual currency. Virtual currency is distinguished from fiat currency (a.k.a. “real currency,” “real money,” or “national currency”), which is the coin and paper money of a country that is designated as its legal tender; circulates; and is customarily used and accepted as a medium of exchange in the issuing country. It is distinct from e-money, which is a digital representation of fiat currency used to electronically transfer value denominated in fiat currency.

The DAO itself was created by the founders of Slock.it as a type of alternative corporation with all corporate functions and governance automated using blockchain and smart contracts. The DAO was the “first generation” of its kind. Participants sent in ETH in exchange for DAO Tokens. DAO Token holders could vote on projects to be used with the DAO assets (ETH, which could be exchanged for fiat currency and other physical or digital assets) and participate in rewards such as profit distributions and dividends. The entire DAO was intended to be autonomous such that project proposals were in the form of smart contracts and voting administered by computer code. The DAO code was launched on the Ethereum blockchain.

The DAO promoted itself through a website which described its purpose (“[T]o blaze a new path in business for the betterment of its members, existing simultaneously nowhere and everywhere and operating solely with the steadfast iron will of unstoppable code”), how it operated, its source code, and a link to buy the DAO Tokens. The DAO was also promoted through media attention and numerous social media channels.

Anyone was eligible to purchase DAO Tokens as long as they paid in ETH and there were no limitations on the number of DAO Tokens offered for sale or the number that could be purchased by any purchaser. There were no parameters set on the accreditation or sophistication level of a purchaser. Anyone with ETH and an ETH blockchain address could participate. All ETH from DAO Token sales were aggregated in the DAO’s Ethereum blockchain address.

Only DAO Token holders could submit proposed projects in which the DAO might participate, and each proposal would have to involve a smart contract and comply with the preset DAO Token holders voting code. Projects would be approved by a majority vote of DAO Token holders. Before being submitted for a vote, projects were to be reviewed by human curators. Although beyond the scope of this blog, there appeared to be many issues with the system, including the programming for voting.

The DAO Tokens were unrestricted and there were several platforms that allowed for the immediate secondary trading of the DAO Tokens.  The secondary market trading platforms were registered with the Federal Crimes Enforcement Network (FinCEN) as Money Services Businesses. For more on FinCEN, see HERE. The DAO Tokens were in fact actively traded on various platforms.

SEC Regulatory Analysis

Section 5 of the Securities Act of 1933, as amended (“Securities Act”) requires the registration of all offers and sales of securities unless there is an available exemption. The registration provisions are based on “full and fair disclosure” of all material information for an investor to make an informed investment decision, including detailed information about the issuer’s financial condition, identity and background of management and the price and amount of securities to be offered.

Section 5 of the Securities Act, like many provisions in the securities laws, is written in the inclusive, such that all offers and sales are covered unless an exemption is available pursuant to statute or case law. Section 5 states that “unless a registration statement is in effect as to a security, it is unlawful for any person, directly or indirectly, to engage in the offer or sale of securities in interstate commerce.” A violation of Section 5 does not require intent.

The SEC begins its analysis of the DAO Tokens by reference to the definitions of a security found in both Section 2(a)(1) of the Securities Act and Section 3(a)(10) of the Securities Exchange Act. Both definitions include the term “investment contract,” which has been famously defined by the U.S. Supreme Court as an investment of money in a common enterprise with a reasonable expectation of profits to be derived from the entrepreneurial or managerial efforts of others. For an in-depth discussion on the definition of a security in SEC v. W. J. Howey Co., 328 U.S. 293 (1946) (the “Howey Test”), see HERE.

Under the Howey Test, whether an investment instrument is a security requires a substance-over-form analysis. The Howey Test defines an investment contract as follows:

“… an investment contract for purposes of the Securities Act means a contract, transaction or scheme whereby a person invests his money in a common enterprise and is led to expect profits solely from the efforts of the promoter or a third party…. Such a definition… permits the fulfillment of the statutory purpose of compelling full and fair disclosure relative to the issuance of the many types of instruments that in our commercial world fall within the ordinary concept of a security…. It embodies a flexible rather than a static principle, one that is capable of adaptation to meet the countless and variable schemes devised by those who seek the use of the money of others on the promise of profits.”

Applying the Howey Test, courts have interpreted a security to include such diverse items as citrus groves, warehouse receipts, chinchillas, minks, diamonds, bullion, pay phones, real estate and equipment, and condominium units, when they were offered or sold under circumstances involving the investment of money and an expectation of a return through the efforts of others.

Applying the Howey Test to the DAO Tokens, the SEC notes that “money” need not include cash, but rather can be anything of value. A contribution of ETH is an investment as considered by the Howey Test. Investors in the DAO were investing in a common enterprise with the expectation of profits, including dividends and increased value. The SEC also found that the profits were to be derived from the efforts of others, including Slock.it, its founders and the DAO curators.

In its analysis of whether the DAO was a security, the SEC spent the most discussion on the “from the efforts of others” factor. Presumably this is because the DAO was established as an autonomous organization with participants voting on all projects. However, the Slock.it team, through its curators, and management of the DAO website and participation in online forums, “led investors to believe that they could be relied on to provide the significant managerial efforts required to make the DAO a success.” Moreover, in fact, the curators and Slock.it team did exercise significant control over proposals and operations of the DAO and were responsible for stopping the hacking attack and coming up with a plan to rectify the situation.

The SEC also noted that the DAO Token holders voting rights were limited. The DAO Token holders could only vote within the rules (code) established by the Slock.it management team. The SEC points to case law related to multi-level marketing schemes which were securities despite the labor put forth by the investors because the promoter dictated the terms and controlled the scheme itself. The SEC stated that “[T]he voting rights afforded DAO Token holders did not provide them with meaningful control over the enterprise, because (1) DAO Token holders’ ability to vote for contracts was a largely perfunctory one; and (2) DAO Token holders were widely dispersed and limited in their ability to communicate with one another.” Furthermore, the SEC questioned the level of disclosure on projects, believing that such disclosure was not “full and fair” such as to allow an informed investment decision.

Upon concluding that the DAO Tokens were securities, the SEC also concluded that the DAO needed to register their issuance, or satisfy a registration exemption, regardless of whether the DAO was incorporated or an unincorporated organization. Issuers, like securities, are broadly defined to include any sponsor or organization that is primarily responsible for the success or failure of the venture. Participants in an offering are also subject to Section 5 obligations and liability. Accordingly, this included the Slock.it founders and principals.

The secondary trading platforms also required registration, or the availability of an exemption, under the federal securities laws. Section 5 of the Exchange Act makes it unlawful for any broker, dealer or exchange to directly or indirectly affect any transaction in a security or report such transaction unless the exchange is registered as a national exchange or exempted from such registration. Section 3(a)(1) of the Exchange Act defines an “exchange” as “any organization, association, or group of persons, whether incorporated or unincorporated, which constitutes, maintains, or provides a market place or facilities for bringing together purchasers and sellers of securities or for otherwise performing with respect to securities the functions commonly performed by a stock exchange as that term is generally understood …”

The functions of a stock exchange generally include: (i) bringing together orders for securities of multiple buyers and sellers; and (ii) using established, non-discretionary methods under which such orders interact with each other, and the buyers and sellers entering such orders agree to the terms of the trade. A frequent exemption to the definition of an exchange is an Alternative Trading System (ATS) that complies with Regulation ATS. Regulation ATS requires, among others, registration as a broker-dealer. The OTC Markets is an ATS, as is t0 Technologies. The platforms that traded the DAO Tokens fit within the definition of an exchange and did not satisfy any available registration exemptions.

Statement by the Divisions of Corporation Finance and Enforcement on the Report of Investigation on the DAO

On the same day that the SEC issued its investigative Report, the Divisions of Corporation Finance and Enforcement issued a statement on the Report. Off the top I notice that the SEC, under Chair Jay Clayton, Commissioner Michael Piwowar and the numerous new executive members, has a decidedly more positive attitude towards business and capital raising overall, than the prior regime. I also notice, through review of enforcement proceedings, that the new regime has not been deterred at all from its mission to detect and prosecute fraud, including micro-cap and penny-stock-related schemes.

To begin its statement, the Divisions noted that DLT, blockchain and other emerging technologies have the potential to influence and improve capital markets and the financial services industry. The Divisions “welcome and encourage the appropriate use of technology to facilitate capital formation and provide investors with new investment opportunities,” and are “hopeful that innovation in this area will facilitate fair and efficient capital raisings for small businesses.” However, new technologies also offer new opportunities for misconduct and abuse.

The Divisions reiterate the SEC Report’s assertion that an offer and sale of securities must comply with the federal securities laws and that determining whether a particular investment opportunity involves a security involves a facts and circumstances analysis, including economic realities and underlying structure, regardless of the terminology or technology used.

Noting that the SEC Report had found that the DAO Tokens were securities, the Divisions caution sponsors and other participants in offerings of digital or other novel forms of value to consider whether they involve a security and thus their obligations under the federal securities laws, including registration or meeting the qualifications for a registration exemption. Market participants that operate a web or other platform that facilitates transactions in securities must also consider whether they need to be registered as a broker-dealer or an exchange, or if there is an available exemption.

Although the Divisions statement does not mention it, keeping in line with the fundamental view that basic securities laws apply, a web platform that meets the criteria set out in Section 4(b) of the Securities Act, as created by the JOBS Act, should qualify for a broker-dealer exemption when hosting digital coin or token offerings. See HERE for details on this exemption.

Furthermore, the Divisions caution that sponsors and other market participants should consider whether their business model results in an entity that needs to be registered as an investment company and whether anyone providing advice about an investment in the security could be an investment advisor.

The Divisions also caution against bad actors and fraud, again using the same principles and tenets that have always applied to economies.  Investors should watch for red flags, including deals that sound too good to be true, promises of high returns with little or no risk, high-pressure sales tactics, and working with unregistered or unlicensed persons.

A fundamental message that I always try to deliver is that anyone engaging in any activity that could invoke the securities laws, should consult with competent securities counsel. The Divisions statement relays the same message, and in particular, that “market participants who are employing new technologies to form investment vehicles or distribute investment opportunities to consult with securities counsel to aid in their analysis of these issues.” The SEC staff also encourages direct communication with the SEC and has set up an email address for communications related to these matters.

Investor Bulletin on Initial Coin Offerings

In addition to its Report and statement of the Divisions of Corporation Finance and Enforcement, on July 25, 2017, the SEC’s Office of Investor Education and Advocacy issued an Investor Bulletin on Initial Coin Offerings (ICO’s). The Investor Bulletin is written in a simple format and helps to inform the public on the basics of ICO’s.

As noted throughout this blog, virtual coins or tokens are created using DLT or blockchain and can be sold in exchange for other virtual coins (such as Bitcoin or Ethereum) or for fiat currency such as U.S. dollars. Generally tokens sold entitle the purchaser to some return on investment or participation in a project and also may be resold or traded on secondary markets, such as virtual currency exchanges. The Investor Bulletin informs the public that these virtual coin or token offerings can invoke the federal securities laws.

The Investor Bulletin provides some basic information on blockchain and virtual currencies. In particular, taken from the Investor Bulletin:

What is a blockchain?

A blockchain is an electronic distributed ledger or list of entries – much like a stock ledger – that is maintained by various participants in a network of computers. Blockchains use cryptography to process and verify transactions on the ledger, providing comfort to users and potential users of the blockchain that entries are secure. Some examples of blockchain are the Bitcoin and Ethereum blockchains, which are used to create and track transactions in Bitcoin and Ether, respectively.

What is a virtual currency or virtual token or coin?

A virtual currency is a digital representation of value that can be digitally traded and functions as a medium of exchange, unit of account, or store of value.  Virtual tokens or coins may represent other rights, as well. Accordingly, in certain cases, the tokens or coins will be securities and may not be lawfully sold without registration with the SEC or pursuant to an exemption from registration.

What is a virtual currency exchange?

A virtual currency exchange is a person or entity that exchanges virtual currency for fiat currency, funds, or other forms of virtual currency. Virtual currency exchanges typically charge fees for these services. Secondary market trading of virtual tokens or coins may also occur on an exchange. These exchanges may not be registered securities exchanges or alternative trading systems regulated under the federal securities laws. Accordingly, in purchasing and selling virtual coins and tokens, you may not have the same protections that would apply in the case of stocks listed on an exchange.

Who issues virtual tokens or coins?

Virtual tokens or coins may be issued by a virtual organization or other capital-raising entity. A virtual organization is an organization embodied in computer code and executed on a distributed ledger or blockchain. The code, often called a “smart contract,” serves to automate certain functions of the organization, which may include the issuance of certain virtual coins or tokens. The DAO, which was a decentralized autonomous organization, is an example of a virtual organization.

The Investor Bulletin continues with warnings to potential investors, including to be aware that the federal securities laws require either registration or an exemption from registration for an offer and sale of securities. The Investor Bulletin points potential investors to the EDGAR database to find registration statements, and reminds investors that exemptions usually are limited to accredited investors.

Further, the Investor Bulletin discusses disclosure obligations and sets forth key information that an investor should be informed of, such as use of proceeds, management and business plans.

The Investor Bulletin points out that even if there has been a fraud or theft, their rights may be limited do to the nature of ICO’s in general, including that they can be autonomous, the inability to trace money, the international scope of offerings, that there is no central controlling authority and that there is no method to freeze or secure virtual currency.  Finally, the Investor Bulletin points to the usual red flags, including “guaranteed” high returns or low risk, unsolicited offers, sounds too good to be true, buying pressure, no net worth or other investor requirements and unlicensed sellers.

Inquiries of a technical nature are always encouraged. Contact us now.

An Introduction To Distributed Ledger Technology (Blockchain Technology)

Posted on by Laura Anthony, Esq.

On July 13, 2017, FINRA held a Blockchain Symposium to assess the use of distributed ledger technology (DLT) in the financial industry, including the maintenance of shareholder and corporate records. DLT is commonly referred to as blockchain. The symposium included participation by the Office of the Comptroller of Currency, the US Commodity Futures Trading Commission (CFTC), the Federal Reserve Board and the SEC.

FINRA also published a report earlier in the year discussing the implications of DLT for the securities industry. Delaware, Nevada and Arizona have already passed statutes allowing for the use of DLT for corporate and shareholder records. This is the first in many blogs that will discuss DLT as this exciting new era of technology continues to unfold and impact the securities markets. In this blog I will discuss FINRA’s report published in January 2017 and in the next in the series, I will summarize the recent SEC investigative report on initial coin offerings and conclusion that cryptocurrencies and tokens are securities. In a follow-on blog, I will summarize the state blockchain legislation to date, including Delaware’s groundbreaking statute.

Blockchain is an openly distributed database which is used to continuously maintain a list of records, called blocks. Each new block is linked to prior blocks in such a way that data cannot be retroactively changed in a prior block without changing all blocks, which is virtually impossible. A DLT ledger is shared among a network of participants, instead of relying on a single central ledger.

Ultimately the blockchain technology could be used to maintain shareholder records in a secure immediate form as well as to process capital markets trades instantaneously. It is thought that stock ledgers and any transfers would be updated instantaneously, effectively allowing for T+0 settlement of trades without the need for intermediaries. A change of this magnitude is many years away as effective regulation and consideration on market impacts will take time. For more on trade settlements, see HERE.

The technology is already being utilized, most notably by the cryptocurrency industry. At least one industry leader, Overstock CEO Patrick Byrne’s t0 Technologies, has created a system that could form the basis for widely used blockchain technology which disrupts the capital market trading systems. I don’t expect quick changes to trading systems and settlement. Blockchain remains widely unregulated and without consensus from top financial regulators, any change to capital market structures will face roadblocks. However, I expect that the ability for public companies to maintain stock ledgers using DLT technology will be forthcoming very soon.

FINRA Report on Distributed Ledger Technology and Implications of Blockchain for the Securities Industry

On July 13, 2017, FINRA held a Blockchain Symposium to assess the use of distributed ledger technology (DLT) in the financial industry.  The symposium followed FINRA’s January 2017 report on DLT and its implications for the securities industry. In recent years, over $1 billion has been invested by various market participants to explore the use of DLT in the financial services industry. Although the level and speed of disruption to current systems remains debated, it is universally agreed that DLT will be utilized in the securities industry. DLT has the potential to completely change business models and practices and as such, regulators realize the necessity to be actively engaged to prepare for the new regime. On a positive note, FINRA views DLT as having the potential to provide investors with greater access to services and transparency and to provide firms with increased operational efficiencies and enhanced risk management.

Many aspects of FINRA’s rules and areas of responsibilities can be impacted by DLT, including, for example, clearing arrangements (it is thought that DLT can eliminate middle-market participants involved in the clearing process), recordkeeping requirements, and trade and order reporting and processing. In addition, FINRA rules such as those related to financial condition, verification of assets, anti-money laundering, know-your-customer, supervision and surveillance, fees and commissions, payment to unregistered persons, customer confirmations, materiality impact on business operations, and business continuity plans also may to be impacted depending on the nature of the DLT application.

DLT is already being used in the securities markets in the form of initial cryptocurrency offerings (ICO’s) and in states that have passed corporate statutes allowing for the use of the technology to maintain corporate and shareholder records. On July 25, 2017, the SEC issued a report on an investigation related to an ICO by the DAO and statements by the Divisions of Corporation Finance and Enforcement related to the investigative report. Although I will write an in-depth blog on the report and statements in the coming weeks, the SEC concluded that the fundamental tenets related to the definition of a security apply and that cryptocurrenciesand tokens that fall within that definition are securities, subject to SEC regulations, regardless of the title or form they may take. For more on decoding what is a security, see HERE.

FINRA’s report on DLT is broken down into three sections including: (i) overview of distributed ledger technology; (ii) DLT securities industry applications and potential impact; and (iii) factors to consider when implementing DLT. FINRA also discussed regulatory requirements and potential changes related to DLT. I will summarize each section with my usual commentary and input.

Overview of Distributed Ledger Technology

DLT involves a distributed database maintained over a network of computers where information can be added by the network participants.  Each added layer of information or data is referred to as a block. The network participants can share and retain identical cryptographically secured information and records.

DLT uses either a public or private network. A public network is open and accessible to anyone that joins, without restrictions. All data stored on a public network is visible to anyone on the network, although it is encrypted. A public network has no central authority and relies solely on the network participants to verify transactions and record data on the network. Algorithm and computational technology is used to protect the integrity of the data.

A private network is limited to individuals and entities that are granted access by a network operator. Access can be tiered with different entities being allowed differing levels of authority to transact and view data. In the financial services industry, it is likely that networks will be private.

The transactions and data on the network usually represent an underlying asset that may be digital assets, such as cryptosecurities and cryptocurrencies, or a representation of a hard asset stored offline (a token representing an interest in a gold bar, for example). Assets on a DLT network are cryptographically secured using public and private key combinations. The public key combination allows access to the network itself, and the private key is for access to the asset itself and is held by the asset holder or its agent.

A transaction may be initiated by any party on the network that holds assets on that network. When a transaction is initiated, it is verified using a predetermined process that can be either consensus-based or proof-of-work based, although new verification processes are being explored. In layman’s terms, the verification process is based on computer computations. The settlement of the transaction is occurs when verification is completed. Currently this can occur immediately or take a few hours.

Once verified, a transaction is “cryptographically hashed” and forms a permanent record on the DLT network. Records are time-stamped and displayed sequentially to all parties with network access. Currently, historical records cannot be edited or changed, though technology is being developed to change that.

DLT Securities Industry Applications and Potential Impact

Currently, market participants are experimenting with several uses of DLT within the market infrastructure and ecosystem. DLT can be used in specific markets, such as debt, equity and derivatives, and in specific market functions, such as clearing. Many discrete applications exist for the use of DLT, including, for example, clearing arrangements, recordkeeping requirements, and trade and order reporting and processing. In addition, DLT can impact financial condition recordkeeping and reporting, verification of assets, anti-money laundering, know-your-customer, supervision and surveillance, fees and commissions, payment to unregistered persons, customer confirmations, materiality impact on business operations, and business continuity plans.

The most common current use of DLT is related to private company equities. DLT can be used to track transfers, maintain shareholder records and for capitalization tables. Nasdaq has utilized DLT technology to complete and record a private securities transaction using its Nasdaq Linq blockchain ledger technology. The Nasdaq platform allows private companies to use DLT to record and track trading of private securities.

DLT will eventually be used for public company equities, but the regulatory aspects are behind the technology. However, Overstock’s Patrick Byrne has created and launched a private platform to allow for public trading of securities using blockchain, called t0 Technologies. The platform only currently trades Overstock’s digital shares, but as an SEC licensed alternative trading system (ATS), the foundation is in place for utilizing the platform to launch and trade public offerings of third-party securities.

The debt market also sees the benefit of DLT. The current average settlement time for the secondary trading of syndicated loans is approximately a month. The repurchase agreement marketplace is filled with inefficiencies, as is the trading market for corporate bonds.  DLT could be used in all aspects of these markets. It is thought that DLT can also be used to automate the derivative marketplace and create greater transparency.

DLT technology is being worked on to create operational processes with the securities industry itself as well, including by creating central repositories of standardized reference data for various securities products, creating efficiencies for all participants. DLT can also centralize identity management functions, on a global scale.

In addition to the centralization of data, DLT can be used to process transactions by using overlaid software. For example, “smart contracts” can be created that would automatically execute agreed-upon terms in a contract based on certain triggering events. Smart contracts can be used for escrow arrangements, collateral management and corporate actions such as dividends and splits.

In addition to discrete areas, DLT can have market-wide impacts as well.  One area that is gaining traction is the clearing process.  Overstock’s platform is called t0 as a play on the widely used T+2 (formerly T+3) time for settlement. t0 references the immediate clearing and settlement of trades using DLT technology. However, despite the technological abilities, FINRA notes that it is unclear what the ideal settlement time would be for various segments of the securities market. Some market participants advocate for a netting and end-of-day settlement rather than a real-time contemporaneous process.

Real-time settlements would also impact short trading and other hedging transactions, including by market makers. On the positive side, it is thought that real-time settlement will reduce market risk, free up collateral and create overall efficiencies. As FINRA notes, it is likely that considerations related to settlement times will differ based on asset type, volume of transactions, liquidity requirements, impact on market makers and current market efficiencies.

Clearly DLT will increase market transparency. The basis of the technology is a series of blocks with a complete history available for view by network participants. Market participants and the investing public could be provided with access to relevant information on the network without the need to create a new reporting infrastructure. FINRA notes that regulators need to consider the benefits of such total transparency and the counter need to protect privacy, personally identifiable information and trading strategies. Also, consideration must be given to the need to ensure that material information available to a private network does not disadvantage the rest of the public.

DLT has the ability to alter or even eliminate the roles of intermediaries in the securities industry. The process of executing a trade as well as the subsequent settlement and clearing of such trade could be done directly between the issuing company and purchaser or third-party buyers and sellers. In addition, the need for market participants that effectuate transaction netting and maintenance of margin requirements could be reduced or eliminated.

The operational risks associated with the securities markets can be changed including sharing information over a network of multiple entities, the use of private and public keys to obtain access to assets, the use of smart contracts and other automated operations. The very nature of DLT as a shared network creates cybersecurity risks and the need for robust countermeasures.

Factors to Consider When Implementing DLT

As discussed, DLT applications have already impacted the securities industry. Many financial institutions have already established in-house or third-party research teams to build and test DLT networks and applications. FINRA’s report provides a good high-level summary of the obvious factors to consider with implementing DLT technology in capital markets, including governance, operational structure and network security.

Governance

A basis of DLT technology is that it is an open network with no centralized governing power or operator. FINRA notes that although there are benefits to this system, there are also issues, such as how to handle a large volume of transactions effectively. As a result, closed networks have started where participants are pre-vetted trusted parties. In the capital markets, questions will need to be answered related to the operation of the network and who has responsibility for what aspects—for example, who would decide governance and internal controls and procedures, who would enforce these governance rules, who would be responsible for day-to-day operations including addressing system failures or technical issues, how errors would be rectified and conflicts of interests addressed.

Operational Structure

Any DLT Network will need to consider its operational structure including a framework for: (i) network participant access and related onboarding and offboarding procedures; (ii) transaction validation; (iii) asset representation (such as shares of stock); and (iv) data and transparency requirements.

A network will need to establish criteria and procedures for establishing and maintaining participating members and determining their level of access. Controls and procedures will need to address: (i) criteria for participants to gain access to the network; (ii) a vetting and onboarding process including identity verification and user agreements; (iii) an offboarding process for both involuntary offboarding as a result of noncompliance and voluntary offboarding; (iv) monitoring and enforcement procedures for compliance with rules of conduct; (v) establishing various levels of access; and (vi) access for regulators.

Networks will need to determine a method for transaction validation. In the short history of blockchain, there have already been different methodologies. Validation could be consensus-based, single-node verifier or multiple-node verifier. Each method has pros and cons, and the specific algorithms and processes would need to be ferreted out.

On the topic of asset representation, networks will need to determine if the actual asset will be directly issued digitally (which only works for certain assets such as intangibles, stock or agreements representing ownership interests) or issued traditionally and be tokenized on the network. If tokenized, further thought must be given to security, handling loss or theft of the underlying asset, fractionalization issues, handling changes such as reverse or forward stock splits or conversions, and new issuances as some examples.

Likewise, thought must be given to the handling of cash on the network, including the settlement of transactions. In that regard, could tokens become a form of cash and if so, how would they ultimately be converted into established government currencies?  Ownership in almost any asset could also be tokenized (such as diamonds, gold, precious metals, art, etc.), creating issues of custodianship and security for the underlying asset. Intangible assets would be relatively easy to tokenize. Fungible assets would be easier than non-fungible assets, with unique assets being the most difficult.

A network will need controls and processes related to data transparency including public or shared information versus private information.

Network Security

In addition to the security of the underlying asset, there are security concerns with the network itself. The issue is more complex due to the decentralized nature of, and global access and participants to, the network. A DLT Network must have security for external and internal risks while maintaining the privacy of personal information for network participants.

Network participants will need to consider: (i) how DLT fits within their current recordkeeping framework including maintenance and backup systems; (ii) cybersecurity issues, including hacking, phishing, malware and other forms of threats and program and testing requirements; (iii) updating written supervisory procedures and policy procedures; and (iv) business controls for identity and transaction verification and fraud prevention.

Regulatory Considerations

Broker-dealers are currently exploring issuing and trading securities, facilitating automated actions such as dividend payments and maintaining transaction records on a DLT network. These areas are regulated by both the SEC and FINRA. The FINRA report points out the potential for a “paradigm shift for several traditional processes in the securities industry through the development of new business models and new practices incorporating DLT” that requires regulatory attention.

I personally believe this shift will occur in a shorter period of time than some others predict. I can see a time in the not-too-distant future where the role of transfer agents is minimalized or completely changed to a reviewer of opinion letters for legend removals; the DTC will be drastically changed and much less powerful; there will no longer be a separation between clearing firms and introducing brokers and all trades will clear instantaneously (t+0).

The FINRA report specifically discusses some major areas of consideration including: (i) customer funds and securities; (ii)

Customer Funds and Securities

DLT will create new ways to hold customer funds and securities and thus custodial changes. Broker-dealers that hold funds and securities must generally comply with Exchange Act Rule 15c3-3, which generally requires the broker to maintain physical possession or control over the customer’s fully paid and excess margin securities. Where funds and securities are purely digital, such as cryptosecurities, consideration will need to be made over how they are accounted for and who has the obligation. In addition, certain activities and access levels could amount to “receiving, delivering, holding or controlling customer assets” such as having access to a private key code for a customer.

Also potentially implicated in this area are Exchange Act Rule 15c3-1 related to net capital requirements, FINRA Rule 4160 on verification of assets and Exchange Act Rule 17a-13 related to quarterly security accounts.

Broker-Dealer Net Capital

Exchange Act Rule 15c3-1 requires a firm to maintain a minimum level of net capital at all times. The FINRA Rule 4100 series sets forth the rules and requirements for complying with net capital requirements including calculations and which assets are allowable or non-allowable within those calculations. Regulations need to address how cryptosecurities, digital currency, and tokens in general will be accounted for, for purposes of net capital calculations.

Books and Records Requirements

Exchange Act Rule 17a-3 and 17a-4 and FINRA Rule 4511 regulate book and record requirements for broker-dealers. DLT allows books and records to be maintained on the network itself, though consideration must be made as to how this will comply with regulations, and what changes need to be made with the regulations to update for the new technology.

Clearance and Settlement

It is my view that DLT could have the biggest impact on clearance and settlement from a pure industry disruption viewpoint. FINRA notes, “Depending on how trade execution and settlement is ultimately structured, broker-dealers and other market participants may wish to consider whether any of their activities in the DLT environment meet the definition of a clearing agency and whether corresponding clearing agency registration requirements under Section 17A of the Exchange Act would be applicable.”

In addition, as mentioned, DLT could eliminate the distinction between introducing and clearing brokers and the corresponding carrying agreement rules.

Anti-Money Laundering and Customer Identification Programs

DLT allows for global and anonymous participation, and accordingly practices and regulations will need to address anti-money laundering (AML) and customer identification obligations (CIP). The Bank Secrecy Act of 1970 requires controls and procedures to detect and prevent money laundering. FINRA Rule 3310 addresses AML obligations.  For more on this topic, see HERE.

In addition, FINRA Rule 2090, the Know Your Customer (KYC) rule, requires firms to “use reasonable diligence, in regard to the opening and maintenance of every account, to know (and retain) the essential facts concerning every customer and concerning the authority of each person acting on behalf of such customer.” Technology is already being explored to centralize identity management functions such that once a customer identity is verified, the information can be shared with all network participants. Obviously this would greatly streamline processes for broker-dealers and customers alike.

It is likely that DLT technology will surpass regulatory changes in the AML/CIP/KYC sectors. The FINRA report notes that the current rules allow a firm to outsource functions to third parties, but not overall responsibility. Accordingly, a firm could utilize DLT technology for these functions now if they can fashion internal controls and procedures that comply with the ultimate rule responsibilities.

Customer Data Privacy

Broker-dealers have an obligation to protect personal customer information (Regulation S-P). The rules also require that a firm provide an annual notice to customers related to the protection, and sharing, of their personal information. DLT by nature will include customer information and transaction histories that will be available to network participants. Regulations, as well as internal controls and procedures, will need to adapt for DLT technology.

Trade and Order Reporting Requirements

FINRA regulates the trading and order reporting requirements for the over-the-counter (OTC Markets) and requires certain reports to a centralized Securities Information Processor for listed securities. DLT may be soon be used for the facilitation of OTC Markets equity transactions. This may involve tokenizing existing securities and trading on a different network. FINRA Rule 6100 Series (Quoting and Trading in NMS Stock), Rule 6400 Series (Quoting and Trading on OTC Equity Securities), Rule 4550 Series (Alternative Trading Systems) and Rule 5000 Series governing offering and trading standards and practices would all be implicated.  I note that t0 Technologies has registered as an ATS.

Supervision and Surveillance

DLT networks will present new and unique challenges related to maintaining supervisory rules and procedures as well as surveillance systems themselves. This area includes the ability to review customer accounts and correct order errors. Like other areas of DLT technology, centralized systems available to all network participants are being developed that can perform some of these functions.

Fees and Commissions

Certain additional fees may be necessary for a DLT network, such as wallet management, key management and on-boarding, whereby other areas may reduce fees as centralization brings economies. In addition, consideration must be given to the payment of fees to third parties that are not registered broker-dealers but that provide DLT outsource functions.

Customer Confirmations and Account Statements

Exchange Act Rule 10b-10 requires firms to provide customers with certain records including trade confirmations and account statements.  DLT technology will change the flow and availability of information.

Material Impact on Business Operations

NASD Rule 1017(a)(5) requires broker-dealers that undergo a material change in business operations to file a Continuing Membership Application (CMA) prior to implementing the material change. Many of the aspects of DLT technology may result in a material change and broker-dealers need to consider the need to file 1017 applications.

Business Continuity Plans

FINRA Rule 4370 requires broker-dealers to maintain business continuity plans. Firms must consider the impact of DLT technology on their plans and update accordingly.

SEC Issues Report On Accredited Investor Definition

Posted on by Laura Anthony, Esq.

On December 18, 2015, the SEC issued a 118-page report on the definition of “Accredited Investor” (the “Report”). The report follows the March 2015 SEC Advisory Committee on Small and Emerging Companies (the “Advisory Committee”) recommendations related to the definition. The SEC is reviewing the definition of “accredited investor” as directed by the Dodd-Frank Act, which requires that the SEC review the definition as relates to “natural persons” every four years to determine if it should be modified or adjusted.

The definition of “accredited investor” has not been comprehensively re-examined by regulators since its adoption in 1982; however, in 2011 the Dodd-Frank Act amended the definition to exclude a person’s primary residence from the net worth test of accreditation.

Although the Report contains detailed discussions on the various aspects of the definition of an accredited investor, the history of the different aspects of the definition, a discussion of different approaches taken in other U.S. regulations and in foreign jurisdictions and an in-depth discussion on the reasoning behind its recommendations, the actual recommendations are only conceptual and broad-based and do not contain specifics. Accordingly, we will need to wait for a future proposed rule release to see what, if any, of the recommendations will be implemented and to what degree. This blog provides a broad summary of the Report.

Background

All offers and sales of securities must either be registered with the SEC under the Securities Act of 1933 (the “Securities Act”) or be subject to an available exemption to registration. The ultimate purpose of registration is to provide investors and potential investors with full and fair disclosure to make an informed investment decision. The SEC does not pass on the merits of a particular deal or business model, only its disclosure. In setting up the registration and exemption requirements, Congress and the SEC recognize that not all investors need public registration protection and not all situations have a practical need for registration – thus the registration exemptions in Sections 3 and 4 of the Securities Act and the rules promulgated thereunder. Exempted offerings carry additional risks in that the level of required investor disclosure is much less than in a registered offering, the SEC does not review the offering documents, and there are no federal ongoing disclosure or reporting requirements.

Regulation D provides the most commonly used transactional exemptions to registration. The SEC notes in its Report that $1.3 trillion was raised under Regulation D in 2014 alone. The definition of “accredited investor” provides the backbone to the Regulation D exemptions and is “intended to encompass those persons whose financial sophistication and ability to sustain the risk of loss of investment or ability to fend for themselves render the protections of the Securities Act’s registration process unnecessary.”

In addition to investor protection, the SEC also has a mandate to assist businesses with capital formation and the definition of “accredited investor” must walk the line between these goals. An overly restrictive definition will damage the ability of businesses to access private capital, and an overly broad definition would be contrary to the SEC’s investor protection goals.

Qualifying as an accredited investor makes the difference between being able to participate in an exempt offering or not, and the ability for an issuer to rely on an exemption or not, and accordingly is a very important component of the securities regulations. For example, some exemptions like Rule 506(c) are limited to accredited investors only. Rules 505 and 506(b) limit offers and sales to no more than 35 unaccredited investors. Many state law exemptions limit offers and sales of securities based on the status of an investor as accredited or not.

An issuer’s required disclosure is also tied into whether investors and potential investors are accredited. For example, under Rules 505 and 506(b) issuers must provide certain delineated financial and non-financial disclosures if an offering will be made to any non-accredited investors.

The Current Definition of “Accredited Investor”

An “Accredited investor” is defined as any person who comes within any of the following categories:

  1. Any bank as defined in section 3(a)(2) of the Act, or any savings and loan association or other institution as defined in section 3(a)(5)(A) of the Act, whether acting in its individual or fiduciary capacity; any broker or dealer registered pursuant to section 15 of the Securities Exchange Act of 1934; any insurance company as defined in section 2(a)(13) of the Act; any investment company registered under the Investment Company Act of 1940 or a business development company as defined in section 2(a)(48) of that Act; any Small Business Investment Company licensed by the U.S. Small Business Administration under section 301(c) or (d) of the Small Business Investment Act of 1958; any plan established and maintained by a state, its political subdivisions, or any agency or instrumentality of a state or its political subdivisions, for the benefit of its employees, if such plan has total assets in excess of $5,000,000; any employee benefit plan within the meaning of the Employee Retirement Income Security Act of 1974 if the investment decision is made by a plan fiduciary, as defined in section 3(21) of such act, which is either a bank, savings and loan association, insurance company, or registered investment adviser, or if the employee benefit plan has total assets in excess of $5,000,000 or, if a self-directed plan, with investment decisions made solely by persons that are accredited investors;
  2. Any private business development company as defined in section 202(a)(22) of the Investment Advisers Act of 1940;
  3. Any organization described in section 501(c)(3) of the Internal Revenue Code, corporation, Massachusetts or similar business trust, or partnership, not formed for the specific purpose of acquiring the securities offered, with total assets in excess of $5,000,000;
  4. Any director, executive officer, or general partner of the issuer of the securities being offered or sold, or any director, executive officer, or general partner of a general partner of that issuer;
  5. Any natural person whose individual net worth, or joint net worth with that person’s spouse, at the time of his or her purchase exceeds $1,000,000, not including their principal residence;
  6. Any natural person who had an individual income in excess of $200,000 in each of the two most recent years or joint income with that person’s spouse in excess of $300,000 in each of those years and has a reasonable expectation of reaching the same income level in the current year;
  7. Any trust, with total assets in excess of $5,000,000, not formed for the specific purpose of acquiring the securities offered, whose purchase is directed by a sophisticated person as described in Rule 506(b)(2)(ii); and
  8. Any entity in which all of the equity owners are accredited investors.

The SEC Report contains an interesting table comparing the regulatory approach to determining the status of investors that are not in need of certain investor protections. I’m reproducing the entire table as appears in the Report:

Standard Financial Threshold for Natural Persons Regulatory Purpose
Accredited Investor(Securities Act Rule 501(a)) $200,000 in income$300,000 in joint income

$1 million in net worth, excluding the value of a primary residence

 Exemption from Securities Act registration for offers and sales to accredited investors
Qualified Client(Advisers Act Rule 205-3) $1 million in assets under management with an investment adviser$2 million in net worth, excluding the value of a primary residence

Subject to inflation adjustment every 5 years

 Exemption from Advisers Act’s prohibition on charging performance fees to clients
Qualified Purchaser(Investment Company Act Section 2(a)(51)(A)) $5 million in investments Exemption from Investment Company Act registration for sales to qualified purchasers
Qualified Investor(Exchange Act Section 3(a)(54)) $10 million in asset-backed securities and loan participations$25 million in other investments Exemption from broker-dealer registration for banks that sell certain securities to qualified investors
Eligible Contract Participant(Commodity Exchange Act Section 1a(18)) $10 million in investments$5 million in investments if hedging Eligible contract participants are able to engage in certain derivatives and swaps transactions

The SEC Report discusses the different approaches and their respective histories. The Report also considers the approach taken by different countries including Australia, Canada, the EU, Israel, Singapore and the United Kingdom. The SEC considered these different approaches in making its recommendations. Although a synopsis of these discussions is beyond the scope of this blog, it does provide for interesting reading and insight into the regulatory regime.

SEC Recommendations Related to the Accredited Investor Definition

The Report considered numerous different approaches and potential changes and contains discussion supporting each element in determining an accredited investor and the recommended changes. The Report discusses the numerous different proposals considered, the input of commenters, the challenges that will be associated with each of its recommendations and the reasoning behind such recommendations. However, notably absent from the Report are specific recommendations associated with the broad concepts.

The SEC staff recommends a complete revision to the definition of accredited investor and in particular makes the following recommendations:

  • Leave the current income and net worth thresholds in place, subject to investment limitations;
  • Create new, additional inflation-adjusted income and net worth thresholds that are not subject to investment limitations;
  • Index all financial thresholds for inflation on a going-forward basis;
  • Permit spousal equivalents to pool their finances for purposes of qualifying as accredited investors;
  • Add a new qualification for individuals based on measures of sophistication including parameters considering the person’s (i) amount of investments; (ii) professional credentials; (iii) experience investing in exempt offerings; and (iv) status as a knowledgeable employee of a private fund for investments in the employer’s fund. In addition, the SEC recommends permitting individuals who pass an accredited investor examination to qualify as an accredited investor.
  • Revise the definition as it applies to entities by replacing the $5 million assets test with a $5 million investments test and including all entities rather than the specifically enumerated types of entities; and
  • Grandfather issuers’ existing investors that are accredited investors under the current definition with respect to future offerings of their securities.

I agree with each of the proposed conceptual changes and in particular the addition of the sophistication qualifications; however, until actual proposals are made that include specifics, such as the specific investment limitations, specific criteria to establish sophistication and specific proposed adjustments, I remain as unspecific in my opinion as the SEC is in its recommendations!

Leaving a strict bright line financial test, without the additional sophistication test, is too restrictive to meet the goal of assisting businesses in accessing capital. According to the SEC Report, in 2013, only 10.1% of U.S. households qualified as accredited investors and adjusting the financial tests for inflation will drop that percent to 3.6%.

The SEC staff points out that there is currently no definition of the term “income” and very limited guidance on the matter. The recommendations do not offer further guidance or suggest any changes. From a practitioner’s perspective, we generally go by the individual’s tax return.

The SEC Report also discussed the net worth calculation. The only asset excluded from the calculation is the person’s primary residence. Many commenters have suggested changes such as the exclusion of retirement assets. The SEC rightfully points out the numerous problems with this approach including, but certainly not limited to, the obvious impact of discouraging retirement investments or encouraging the withdrawal of retirement funds to participate in private investments. Moreover, the Advisory Committee previously pointed out, and the SEC Report acknowledges, that “retirement assets” refer to a tax treatment and not a class of assets, and can be anything from an IRA to racehorses, to bitcoins, to real estate and anything in between. Retirement assets are not classified based on risk and are not somehow risk-protected. Many of the most experienced, wealthiest investors have the majority of their portfolio in assets that receive “retirement assets” tax treatment, and there is no justification for excluding tax-protected accounts from the accredited definition.

I also like the reasoning behind adding investment limitations at certain thresholds and removing them at higher thresholds. Currently the income and net worth tests are absolute. An investor with a $999,999 net worth cannot invest and an investor with a $1,000,000 can invest an unlimited amount. Permitting all individuals that with a level of financial sophistication to be deemed accredited and invest in private offering subject to caps based on net worth or income, will greatly expand the pool of potential investors and be consistent with the need to protect investors.

The SEC Reports suggests a few methods of implementing investment limitations but does not make a specific, precise proposal. The SEC Report suggests examples of limitations such as: (i) an even percentage application across all investors (this approach is rejected); (ii) a gradual increase in investment limitation which limitation is eventually eliminated based on net worth and/or income; and (iii) either separately or in conjunction with other limitations, adding a per issuer limitation.

The SEC Staff recommendations in the Report are consistent with the Advisory Committee’s recommendations made to the SEC in March 2015. In particular, the Advisory Committee made four recommendations related to the definition of “accredited investor”:

(1) That if any change is made to the definition of “accredited investor,” such change should “have the effect of expanding, not contracting, the pool of accredited investors.” For example, they recommended that the definition include investors that satisfy a sophistication test that is not tied to income or net worth. In addition, the Advisory Committee recommended that that tax treatment of assets be excluded from any net worth calculation.

(2) That the SEC take into account the effect of inflation and adjust the accredited investor thresholds in accordance with the consumer price index.

(3) “Rather than attempting to protect investors by raising the accredited investor thresholds or excluding certain asset classes from the calculation to determine accredited investor… the Commission should focus on enhanced enforcement efforts and increased investor education” and

(4) The SEC should continue to gather data on the subject.

Additional History and Further Background

The vast majority of the SEC’s 118-page report provides a history of the Securities Act registration and exemption provisions and the role of the accredited investor definition. The SEC provides the background of the Section 4(a)(2) exemption and a summary of SEC vs. Ralston Purina Co., the leading Supreme Court case interpreting the provision. I’ve previously covered some of this history in my blogs HERE and HERE (written prior to renumbering 4(2) to 4(a)(2)). The following blog HERE on obstacles in depositing penny stocks also provides insight into the exemptions and investor qualifications and as such is beneficial ancillary reading with this blog.

The Advisory Committee Letter to the SEC in March 2015 contained a list of practical facts and realities related to small business and emerging company capital formation in support of its recommendations that I found informative and so am re-publishing. In particular:

  • Smaller and emerging companies are “critical to the economic well-being of the United States,” generating the majority of net new jobs in the last five years and continuing to add more jobs;
  • Rule 506 of Regulation D is the most widely used private offering exemption, resulting in $1 trillion of raised capital in 2013;
  • Most early-stage, venture capital and angel investments are made in reliance on Rule 506;
  • Other than Rule 506(b), which allows up to 35 unaccredited investors (when certain disclosures and financial information are provided), all investors in Rule 506 offerings must be accredited;
  • The Dodd-Frank Act requires the SEC to review the accredited investor definition to determine whether it “should be adjusted or modified for the protection of investors, in the public interest, and in light of the economy”;
  • There are groups and commentators that advocate increasing the thresholds in the accredited investor definition to prevent fraud against investors. However, the SEC is not of “any substantial evidence suggesting that the current definition of accredited investor has contributed to the ability of fraudsters to commit fraud or has resulted in greater exposure for potential victims.” In addition, “the connection between fraud and the current accredited investor thresholds seems tenuous at best”;
  • Some groups and commentators advocate excluding “retirement assets” from the calculation of net worth. The Advisory Committee rightfully and logically points out that “retirement assets” refer to a tax treatment and not a class of assets, and can be anything from an IRA to racehorses, to bitcoins, to real estate and anything in between. Retirement assets are not classified based on risk and are not somehow risk-protected. Many of the most experienced, wealthiest investors have the majority of their portfolio in assets that receive “retirement assets” tax treatment, and there is no justification for excluding tax-protected accounts from the accredited definition; and
  • There is little or no evidence to suggest that the existing definition of accredited investor has led to widespread fraud or other harm to investors; rather, there is substantial evidence that the current definition works.

The Advisory Committee concluded that if the income and net worth thresholds are increased, it “will materially decrease the pool of capital available for smaller businesses.” It continued by stating that such a change “would have a disparate impact on those areas having a lower cost of living, which areas often coincide with regions of lower venture capital activity.”

SEC Issues Investor Alert Warning That Fantasy Stock Trading Websites May Violate Securities Laws

Posted on by Laura Anthony, Esq.

At the end of June, the SEC Office of Investor Education and Advocacy issued an Investor Alert and reminded us all that the net of federal securities laws is far-reaching.  The Investor Alert warns investors that fantasy stock trading and similar websites violate federal securities laws and, in particular, the “security-based swap” regulations enacted by the Dodd-Frank Act.

The SEC Investor Alert warns against websites that claim to offer a chance to make money from publicly traded or privately held companies without actually buying stock.  Generally the sites are set up as a “fantasy” trading game or competition and involve a small entry fee with the chance to win a larger payment if you win the fantasy competition.  The SEC has taken the position that these fantasy stock trading programs could potentially involve security-based swaps and implicate both the federal securities and commodities laws.  The SEC has and is continuing to investigate the matter.  The investigation has progressed enough that the SEC found it prudent to issue the Investor Alert.

Security-based Swaps

Like the definition of a security itself, a “security-based swap” is broadly defined.  A “swap” is a financial contract in which two or more counterparties agree to exchange or “swap” payments with each other as a result of such things as changes in stock price, interest rate or commodity price.  In other words, a swap includes any agreement, contract, or transaction whose value is based upon the value or performance of some other financial product, event or characteristic.

Generally, practitioners and the marketplace consider a security-based swap to be a derivative or other complicated financial instrument that only the most sophisticated institutional investors and brokerage houses participate in.  For the most part, that is entirely true and correct.  The national exchanges do not provide a trading platform for security-based swaps.  Rather, a whole trading regime and marketplace has been established around the multi-trillion-dollar swaps market, including security-based swap execution facilities, security-based swap data repositories, security-based swap clearing agencies and a swap-based over-the-counter market.  This is not to be confused with the OTC Marketplace for equity securities, which is a distinct and separate marketplace for the trading of unlisted securities (i.e., OTC Pink, OTCQB and OTCQX).

Historically, security-based swaps were not addressed in federal regulations.  In 2000, Congress actually specifically removed security-based swaps from the SEC’s jurisdiction.  In particular, in 2000, Congress passed the Commodity Futures Modernization Act (CFMA) to provide legal certainty for swap agreements. The CFMA explicitly prohibited the SEC and CFTC from regulating the over-the-counter swaps markets, but provided the SEC with antifraud authority over “security-based swap agreements,” such as credit default swaps.  By preventing specific anti-fraud regulation but allowing anti-fraud jurisdictional authority, the CFMA tied the SEC’s hands and created an unworkable regulatory framework.

The Dodd-Frank Act addressed the gap and provided a broad, comprehensive regulatory framework for the OTC swaps market.  The Dodd-Frank Act divided regulatory authority over swap agreements between the SEC and CFTC as well as other regulators such as the Federal Reserve Board related to banking swap entities.  The SEC’s authority is over “security-based swaps.”  Security-based swaps are included within the definition of “security” under the Securities Exchange Act of 1934 and the Securities Act of 1933.  The CFTC has primary authority over commodity-based swaps, and the SEC and CFTC share authority over mixed swaps.

Implementation of the Dodd-Frank Act related to swaps has required numerous rules and a prolific volume of complicated rule releases.  The CFTC and SEC are required to act jointly to define key terms relating to jurisdiction (such as swap, security-based swap, and security-based swap agreement) and market intermediaries (such as swap and security-based swap dealers and major swap and security-based swap participants), as well as adopt joint regulations regarding mixed swaps and prescribe trade repository recordkeeping requirements, and books and records requirements for swap entities related to security-based swap agreements. The SEC is required to consult with the CFTC and the Federal Reserve Board on non-joint rulemakings and with the other prudential regulators on capital and margin rules. The CFTC, SEC and U.S. regulators also consult with non-U.S. regulatory authorities on the establishment of consistent international standards for the international swaps market.

My practice and clientele usually do not require me to delve into the rules, regulations and practical operations of swaps in general or even the more defined security-based swaps.  However, this new Investor Alert directed towards the same average investor that trades in the OTC Marketplace and national securities exchanges caught my attention and is worth a discussion.

Fantasy Stock Trading

The SEC anti-fraud provisions apply to all transactions in security-based swaps regardless of the sophistication or wealth of the investors.  Initially it is helpful to know a few terms.  First, an investor or participant in the swaps market is called a “counterparty” or “counterparties.”  Second, an “eligible contract participant” or “ECP” is specifically defined in the securities laws (much like an “accredited investor”) and includes, for example, people who have more than $10 million invested on a discretionary basis.  The federal securities laws contain many provisions related to the offer or sale of security-based swaps to persons who are not eligible contract participants.  A registration statement must be filed and effective prior to offering a swap to a non-ECP, and the swap contracts must be sold on a national exchange.

The SEC notes that there are many different ways that virtual games references securities involve a security-based swap.  For example, the SEC believes a security based-swap would encompass a website could charge an entry fee to play a game involving the “purchase” or “sale” of securities and the ability to win a prize for such efforts.  As with other fantasy games, no actual particular company’s securities would be purchased or sold.  Each site and fact scenario requires a review and analysis as to whether it involves a security-based swap, has invoked the federal securities laws, and has complied with such laws.

Taking the position that a fantasy stock trading website could be a security-based swap, the operation of the site and offer to the public to participate requires an analysis as to whether the persons receiving the offer are eligible contract participants and if they are not, ensuring the proper disclosures and rules related to offers to non-eligible contract participants are complied with.  I am certain that none of the operators of these sites have made such an analysis or complied with the applicable federal securities laws.

The SEC recently filed and settled an action In the Matter of Sand Hill Exchange. Garrit Hall and Elaine Ou, in which the SEC issued a cease-and-desist order against a website operator and its principals.  The particular site claimed to offer anyone an opportunity to realize profits based on the performance of private pre-IPO companies.  The website offered to sell “contracts” referencing the pre-IPO company.  If the pre-IPO company had a liquidity event, such as an IPO, merger or acquisition, the contract buyer would receive payment on the contract based on a value calculation.  The SEC found that the contracts were firmly within the definition of a security-based swap and shut down the site.

Other Warnings

The SEC Investor Alert also reminds the public that the federal securities laws are in addition to and separate from other federal laws, such as the federal gambling laws.  A website may be operating in compliance with the Unlawful Internet Gambling Enforcement Act of 2006 and still be violating federal securities laws.

Moreover, the SEC stresses that consideration or payment can be in any form, not just cash.  The payment to a website or third party in bitcoins, virtual currency, traded goods or services, or anything of value, invokes the securities laws to the exact same extent as the payment in cash.

Conclusion

The purpose of the SEC Investor Alert is to warn the general public against these websites and really any website that requires payment to “play” or participate in a game or other “investment” that may not appear to be a security on its face.  From my perspective, the Investor Alert is a reminder to all entrepreneurs that the federal securities laws are all-encompassing and must be considered in any and all business models.  For additional information regarding the definition of a security, please see my blog HERE.

 

SEC Sanctions BITCOIN Exchange Operator-A Case Study In Basic Registration And Exemption Requirements

Posted on by Laura Anthony, Esq.

On December 8, 2014, the SEC settled charges against a creative, but ill informed, entrepreneur for acting as an unlicensed broker-dealer and for violations of Section 5 of the Securities Act of 1933, as amended.  Ethan Burnside and his company, BTC Trading Corp., operated two online enterprises, BTC Virtual Stock Exchange and LTC-Global Virtual Stock Exchange, that traded securities using virtual currencies, bitcoin or litecoin.  Neither of these exchanges were registered as broker-dealers or stock exchanges.  In addition, Burnside and his company conducted separate transactions in which he offered investors the opportunity to use virtual currencies to buy or sell shares in the LTC-Global exchange itself and a separate litecoin mining venture he owned and operated.  These offerings were not registered with the SEC as required under the federal securities laws.

According to the SEC release on the matter, “the exchanges provided account holders the ability to use bitcoin or litecoin to buy, sell, and trade securities of businesses (primarily virtual currency-related entities) listed on the exchanges’ websites.  The venues weren’t registered as broker-dealers despite soliciting the public to open accounts and trade securities.  The venues weren’t registered as stock exchanges despite enlisting issuers to offer securities for the public to buy and sell.” The exchanges charged and collected transaction-based compensation for each executed trade on the platforms.

“Burnside operated two online enterprises that weren’t properly registered to engage in the securities business they were conducting,” said Andrew M. Calamari, Director of the SEC’s New York Regional Office.  “The registration rules are vitally important investor protection provisions, and no exemption applies simply because an entity is operating on the Internet or using a virtual currency in securities transactions.”

Because Burnside cooperated with the SEC, he was able to settle the charges for only $68,000 and a bar from acting in the securities industry with the right to re-apply after two years.  The SEC release notes that “the penalty amount reflects prompt remedial acts taken by Burnside as he cooperated with the SEC’s investigation.”

The SEC did not make any allegations related to fraud.  The SEC’s news release did not contain any negative inflammatory language against Burnside or his entities, and his penalty was extremely light for today’s regulatory environment.  Burnside has the ability to apply to re-enter the securities business after two years.  Clearly Burnside tried to create and operate a valid business, and more than that, he did a good job of it.

Burnside, however, failed to comply with and (obviously) seek the advice of experienced securities counsel.  On the highest level, Burnside failed to follow the most basic premises of securities transactions: (i) registration or exemption as a broker-dealer; (ii) registration or exemption of an exchange; (iii) registration or exemption for the sale of DTC and LTC securities; and (iv) ensuring either registration or exemption for the sale of listed issuer’s securities.  Admittedly, the process for each of these items can be complicated, expensive and time-consuming, but every entrepreneur that is considering engaging in a business that involves securities on any level needs to consider these basic high-level issues before proceeding.

How BTC and LTC Worked

Both BTC and LTC operated as online bitcoin- and litecoin-denominated stock exchanges.  Using bitcoins or litecoins as the currency, users bought, sold and traded securities in both initial and secondary offerings of businesses listed on the website.  Although the sites were open to anyone, they became popular with virtual currency enthusiasts, and most of the issuers on the site were currency-related businesses, including virtual currency mining operations.  According to the SEC release, a virtual currency “miner” is “an individual or entity that participates in a decentralized virtual currency network by running special software to solve complex algorithms in a distributed proof-of-work or other distributed proof system used to validate transactions in the virtual currency system. Certain virtual currencies (e.g., bitcoin and litecoin), self-generate units of the currency by rewarding miners with newly created coins.”

There were no restrictions on who could open an account, which account opening was completed using a simple online registration form.  The only information required was an e-mail address, and accordingly, account holders could be anonymous.  There were no restrictions or even information requests related to accreditation or sophistication.  Once registered, users could view their account history and balance online.  Deposits of bitcoins and litecoins were made using software, and such deposits were maintained by BTC and LTC and commingled in a single virtual wallet.  Users could withdraw their currency at any time.  The sites strictly operated in bitcoins and litecoins and did not offer any method to convert the virtual currency to USD or other currencies.

Users could place trades in the securities of the listed issuers, including straight purchases and sales and option trades.  Users would enter a bid or ask through an online order book.  Trades were matched using a software system and all trades, quotes and dividends were publicly displayed on the site.  The site also reported such information as trading volume for issuers.  The trading on the sites was completely self-contained; that is, no trades were routed to outside venues or sources. BTC and LTC charged transaction-based compensation for executing trades

In order for an issuer to offer and sell securities, it would submit an online application and an investment contract for the purchase of its securities.  The issuer’s application included a description of its business and the investment being offered.  LTC and BTC charged a flat fee for listing.  The issuers also agreed to a “terms of service” that included various representations and warranties by the issuer, including that its business was “legal in the United States.”  BTC and LTC shareholders approved all issuers through an online voting process.

Once approved, the issuer could list and sell securities.  No certificates were issued for sold securities, but rather ownership of shares was recorded in line account statements that were updated and provided to shareholders every 12 hours.  The issuers were able to upload and post business plans and other marketing materials, post updates and new releases and otherwise communicate with their shareholder base and prospective investors.  BTC and LTC acted as limited moderators over the postings.  Burnside also regularly posted on his own sites and others soliciting users for the sites.

BTC and LTC also listed and sold its own securities on the sites.  Each of the issuers, including BTC and LTC, engaged in general solicitation in the sale of securities.  Upon being contacted by the SEC, Burnside promptly completed an orderly wind-down of both sites.

None of the issuers registered their securities or the offerings with the SEC.  None of the issuers took steps to ensure an exemption from registration was available, such as limiting the offerings to accredited investors only, verifying accredited status when using general solicitation, providing specified disclosure documents, or complying with state blue sky laws.

Registration or exemption as a broker-dealer

Subject to limited exemption, the Exchange Act makes it unlawful for any broker or dealer to “effect any transaction in, or to induce or attempt to induce the purchase or sale, of any security…unless such broker or dealer is registered.”  The Exchange Act defines a “broker” as “a person, including a company, engaged in the business of effecting transaction in securities for the account of others.”  Case law indicates that a person is engaged in the business of effecting securities transactions if he or she “regularly participates in securities transactions at key point in the chain of distribution.”

In addition, in accordance with the SEC Guide to Broker-Dealer Registration, providing any of the following services may require the individual or entity to be registered as a broker-dealer:

  • “finders,” “business brokers,” and other individuals or entities that engage in the following activities:investment advisers and financial consultants;
    • Finding investors or customers for, making referrals to, or splitting commissions with registered broker-dealers, investment companies (or mutual funds, including hedge funds) or other securities intermediaries;
    • Finding investment banking clients for registered broker-dealers;
    • Finding investors for “issuers” (entities issuing securities), even in a “consultant” capacity;
    • Engaging in, or finding investors for, venture capital or “angel” financings, including private placements;
    • Finding buyers and sellers of businesses (i.e., activities relating to mergers and acquisitions where securities are involved);
  • persons that market real estate investment interests, such as tenancy-in-common interests, that are securities;
  • persons that act as “placement agents” for private placements of securities;
  • persons that effect securities transactions for the accounts of others for a fee, even when those other people are friends or family members;
  • persons that provide support services to registered broker-dealers; and
  • persons that act as “independent contractors” but are not “associated persons” of a broker-dealer

There are several exemptions from broker-dealer registration.

Title II of the JOBS Act created a limited exemption to the broker-dealer registration requirements for certain intermediaries that facilitate Rule 506 offerings.  In particular, Section 4(b) of the Securities Act of 1933 (“Securities Act”) added an exemption to the broker-dealer registration requirements such that an individual or entity will not be deemed a broker-dealer as a result of the following:

(A)  That person maintains a platform or mechanism that permits the offer, sale, purchase, or negotiation of or with respect to securities, or permits general solicitations, general advertisements, or similar or related activities by issuers of such securities, whether online, in person, or through any other means;

(B)  That person, or any person associated with that person, co-invests in such securities; or

(C)  That person, or any person associated with that person, provides ancillary services with respect to such securities.

Ancillary services are defined as (i) the provision of due diligence services in connection with the offer, sale, purchase, or negotiation of such security, so long as such services do not include, for separate compensation, investment advice or recommendations to issuers or investors; and (ii) the provision of standardized documents to the issuers and investors, so long as such person or entity does not negotiate the terms of the issuance for and on behalf of third parties and issuers are not required to use the standardized documents as a condition of using the service.

The exemption from registration as a broker or dealer also requires that such person and each person associated with such person (i) does not receive any compensation in connection with the purchase or sale of the security; (ii) does not have possession of customer funds or securities in connection with the purchase or sale; and (iii) is not subject to statutory disqualification pursuant to Section 3(a)(39) of the Exchange Act (i.e., bad boy provisions).

Burnside could potentially have operated a Title II exempt website geared towards bitcoin and litcoin investments.  For a discussion as to how this could be structured, see my blog HERE.

Registration or exemption of an exchange

Section 5 of the Exchange Act of 1934, as amended, makes it unlawful for any broker, dealer, or exchange, directly or indirectly, to effect any transaction in a security, or to report any such transaction, in interstate commerce, unless the exchange is registered as a national securities exchange or is exempted from such registration. Section 3(a)(1) of the Exchange Act defines an “exchange” as “any organization, association, or group of persons, whether incorporated or unincorporated, which constitutes, maintains, or provides a market place or facilities for bringing together purchasers and sellers of securities or for otherwise performing with respect to securities the functions commonly performed by a stock exchange as that term is generally understood….”  Exchange Act Rule 3b-16 further defines an exchange to mean “an organization, association, or group of persons that: (1) brings together the orders for securities of multiple buyers and sellers; and (2) uses established, non-discretionary methods (whether by providing a trading facility or by setting rules) under which such orders interact with each other, and the buyers and sellers entering such orders agree to the terms of the trade.” The Commission has also stated that “an exchange or contract market would be required to register under Section 5 of the Exchange Act if it provides direct electronic access to persons located in the U.S.”

Clearly LTC and BTC operated as an exchange, without registration or an exemption.  Under almost any analysis, LTC and BTC would have been required to register as an exchange to operate as it did.

Registration or exemption for the sale of securities

Burnside offered and sold securities of BTC, LTC and his virtual currency mining business without either an effective registration statement or available exemption.  In addition, each of the issuers on the BTC and LTC websites offered and sold securities without either an effective registration statement or available exemption.  All issuers engaged in general solicitation in relation to the sale of securities.

Section 5 of the Securities Act of 1933 makes it is unlawful for any person to directly or indirectly “offer” or “sell” securities without a valid effective registration statement unless an exemption is available.  Companies desiring to offer and sell securities to the public with the intention of creating a public market or going public must file a registration statement containing all material information concerning the company and the securities offered with the SEC and provide that filed registration statement to prospective investors.  The registration statement is filed using a form S-1.  None of the issuers in this case filed a registration statement with the SEC.

In lieu of registration, each issuer would need to satisfy an exemption from registration.  Although other exemptions may have been available, the most obvious potential exemption for the issuers in this case would be 506(c).  Rule 506(c) permits the use of general solicitation and advertising to offer and sell securities under Rule 506, provided that the following conditions are met:

1.the issuer takes reasonable steps to verify that the purchasers are accredited;
2.all purchasers of securities must be accredited investors, either because they fit within one of the categories in the definition of accredited investor, or the issuer reasonably believes that they do, at the time of the sale; and

3.all terms and conditions of Rule 501 and Rules 502(a) and (d) must be satisfied.

For an in-depth discussion on Rule 506(c), see my blog HERE.

Inquiries of a technical nature are always encouraged. Contact us now.