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On April 3, the SEC issued a no-action letter to a Delaware-based airline chartering services company not recommending enforcement action for offering and selling “tokens” without registration under the SEC Act. According to the letter, the SEC relied upon the company’s counsel’s opinion, which assured that consumers are purchasing the tokens solely for prepaid “air charter services and not for investment purposes or with an expectation to earn a profit,” in determining that the “tokens” were not securities. Additionally, the SEC’s relief considered numerous other factors such as: (i) the platform for conducting the sale of the tokens will “be fully developed and operational” at the time any tokens are sold and funds derived from token sales will not be used to develop the platform; (ii) consumers will be able to immediately use the tokens for their intended functionality (i.e., to purchase air charter services) at the time of sale; (iii) the company will restrict the transfer of tokens to company wallets only and not to external wallets; (iv) the tokens will be sold for one dollar to be used solely on the platform to purchase air charter services, and will be treated as having a value of one dollar; (v) if the company offers to repurchase tokens, it will do so at a discount to the face value of the tokens that the holder seeks to resell to the company, unless a court orders the company to liquidate the tokens; and (vi) the tokens will not be marketed in such a way that there is a perceived potential for an increase in the token’s market value.
On February 20, the SEC announced a cease-and-desist order with a cybersecurity startup for conducting an unregistered Initial Coin Offering (ICO), which the company self-reported. According to the order, in late 2017, the startup conducted an unregistered ICO, which raised approximately $12.7 million in digital assets. The money was used to finance the startup’s plan to “develop a network in which participants could rent spare bandwidth and storage space on their computers and servers to others for use in defense against certain types of cyberattacks.” The SEC noted that the tokens offered and sold were considered securities because a purchaser would have a reasonable expectation of obtaining a future profit from the investment. The startup did not register the ICO nor did it qualify for an exemption to the registration requirements. The SEC did not impose a monetary penalty because, according to the order, in the summer of 2018 the startup self-reported the unregistered ICO and offered to take prompt remedial actions. The order requires the startup to return the funds to investors who purchased the tokens and register the tokens as securities.
District Court rejects dismissal bid, determining plaintiff sufficiently alleged ICO tokens were unregistered stock
On December 10, the U.S. District Court for the District of New Jersey denied a motion to dismiss a putative class action, finding the plaintiff sufficiently alleged that a company’s sale of unregistered cryptocurrency tokens were “investment contracts” under securities law. According to the opinion, the plaintiff filed the proposed class action against the company alleging it sold unregistered securities in violation of the Securities Act after purchasing $25,000 worth of tokens during the company’s initial coin offering (ICO). The company moved to dismiss the complaint, arguing that the tokens were not securities subject to the registration requirements of the Act. The court applied the three-prong “investment contract” test from SEC v. W.J. Howey Co.—“the three requirements for establishing an investment contract are: (1) an investment of money, (2) in a common enterprise, (3) with profits to come solely from the efforts of others”—and determined the token sales met the requirements. Focusing on the second and third prongs, because the company acknowledged the first was satisfied, the court concluded that the plaintiff sufficiently alleged the existence of a common enterprise by showing a “horizontal commonality” from the pooling of the contributions used to develop and maintain the company’s tasking platform. As for the third prong, the court determined the investors had an expectation of profit rather than simply a means to use the tasking platform, as demonstrated by the company’s marketing of the ICO as a “‘unique investment opportunity’ that would ‘generate better financial returns[.]’”
On November 27, the U.S. District Court for the Southern District of California denied the SEC’s motion for a preliminary injunction against a cryptocurrency company, concluding the agency failed show the currency tokens were “securities” as defined under federal securities laws. According to the order, the SEC filed a complaint against the company in October alleging it falsely claimed its initial coin offering (ICO) was registered and approved by the SEC and other regulators, including using the agency’s seal in marketing materials. At the time of the filing, the SEC claimed the company had already raised more than $2.5 million in pre-ICO sales. The SEC moved for a preliminary injunction to freeze the company’s assets and prevent the company’s owner from buying or selling securities and other digital currency during the pendency of the case. Upon review, the court noted the SEC must establish the company previously violated federal securities laws and there is a reasonable likelihood that it will happen again. The SEC argued the allegedly fraudulent marketing materials used to raise money from 32 “test investors” violated federal securities laws, while the company argued the investors did not have an expectation to receive profits as they were working with the company on the exchange’s functionality and therefore, the currency tokens were not “securities.” The court denied the SEC’s motion, concluding that it could not determine whether the tokens were “securities” under federal law without full discovery as there were disputed issues of material facts, including what the test investors relied on in terms of marketing materials before they purchased the cryptocurrency tokens.
On November 16, the SEC announced cryptocurrency-related settlements imposing civil money penalties against two companies that allegedly offered and sold digital tokens through initial coin offerings (ICO). The settlements are the SEC’s first cases imposing civil money penalties based solely on alleged ICO securities offering registration violations. According to the SEC, the two companies allegedly violated the Securities and Exchange Act of 1934 by offering and selling ICO tokens without (i) registering them pursuant to federal securities laws; or (ii) qualifying for an exemption to registration requirements. Under the terms of the settlement agreements (available here and here), the companies—who have neither admitted nor denied the findings—have each agreed to pay a $250,000 civil money penalty, and will also (i) return funds to impacted investors; (ii) register the digital tokens as securities; and (iii) file periodic reports with the SEC.
On November 20, the Colorado Department of Regulatory Agencies Division of Securities (Division) released a statement announcing four new cease-and-desist orders taken against companies for allegedly selling unregistered securities through initial coin offerings (ICOs) to Colorado consumers. The orders come as a result of investigations conducted by the Division’s ICO Task Force, which was created to investigate potentially fraudulent activity. According to the announcement, the Colorado Securities Commissioner has now signed orders for 18 cases against ICOs, and currently has at least two additional pending orders.
On September 11, the U.S. District Court for the Eastern District of New York issued a ruling that the U.S. government can proceed with a case for purposes of federal criminal law against a New York-based businessman who allegedly made “materially false and fraudulent representations and omissions” connected to virtual currencies/digital tokens backed by investments in real estate and diamonds sold through associated initial coin offerings (ICOs). The defendant—who was charged with conspiracy and two counts of securities fraud for his role in allegedly defrauding investors in two ICOs—claimed that the ICOs at issue were not securities but rather currencies, and that U.S. securities law was unconstitutionally vague as applied to ICOs. However, the U.S. government asserted that the investments made in the tokens were “investment contracts” and thereby “securities” as defined by the Securities Exchange Act. The U.S. government further argued that the jury should apply the central test used by the U.S. Supreme Court in SEC v. W.J. Howey Co. to determine if a financial instrument “constitutes an ‘investment contract’ under the federal securities laws.” The judge commented that “simply labeling an investment opportunity as ‘virtual currency’ or ‘cryptocurrency’ does not transform an investment contract—a security—into a currency.” Moreover, while the judge cautioned that it was too early to determine whether the virtual currencies sold in the ICOs were covered by U.S. securities law, he concluded that a “reasonable jury” may find that the allegations in the indictment support such a finding.
On August 9, Financial Crimes Enforcement Network (FinCEN) Director Kenneth A. Blanco delivered remarks at the 2018 Chicago-Kent Block (Legal) Tech Conference to discuss, among other things, the agency’s approach to virtual currency and its efforts to protect financial institutions from being exploited for illicit financing purposes as new financial technologies evolve and are adopted. Blanco commented that while innovation provides customers with greater access to financial services, it can also create opportunities for criminals or serve as a vehicle for fraud. Blanco discussed several areas of focus, such as (i) the regulation of virtual currency and initial coin offerings (ICOs), along with coordinated policy development and regulatory approaches done in conjunction with the SEC and CFTC; (ii) examination and supervision efforts designed to “proactively mitigate potential illicit finance risks associated with virtual currency”; (iii) anti-money laundering/countering the financing of terrorism (AML/CFT) regulatory compliance expectations for companies involved in ICOs or virtual currency transmissions; (iv) enforcement actions taken against companies that fail to implement effective programs; (v) the rise and importance of virtual currency suspicious activity report filings which help the agency identify and investigate illicit activity; and (vi) the development of an information sharing virtual currency-focused FinCEN Exchange program. Blanco emphasized that “individuals and entities engaged in the business of accepting and transmitting physical currency or convertible virtual currency from one person to another or to another location are money transmitters subject to the requirements” of the Bank Secrecy Act.
On July 16, the CFTC issued an advisory to alert customers to exercise caution and conduct thorough research prior to purchasing virtual/digital coins or tokens. Specifically, customers are reminded (i) to conduct extensive due diligence on all “individuals and entities listed as affiliates of a digital coin or token offering”; (ii) to confirm whether the digital coins or tokens are securities and, if so, verify that the offering is registered with the SEC before investing in an Initial Coin Offering (ICO); (iii) to verify how the money will be utilized, if they can get it back, and what rights the digital coin or token provides; and (iv) that many ICOs are frauds.
On July 16, the Financial Stability Board (FSB) published a report, which asserts that, while “crypto-assets do not pose a material risk to global financial stability at this time,” there exists a need for “vigilant monitoring in light of the speed of developments and data gaps.” According to “Crypto-assets: Report to the G20 on work by the FSB and standard-setting bodies” (the Report), the FSB and the Committee on Payments and Market Infrastructures (CPMI) have developed a framework to monitor and assess vulnerabilities in the financial system resulting from developments in the crypto-asset markets. As previously covered in InfoBytes, the FSB earlier released a letter to G20 Finance Ministers and Central Bank Governors in March noting that “[c]rypto-assets raise a host of issues around consumer and investor protection, as well as their use to shield illicit activity and for money laundering and terrorist financing.” The Report specifically discusses actions being undertaken by international regulatory bodies, including (i) the CPMI’s investigation into distributed ledger technologies and monitoring of payment innovations; (ii) the International Organization of Securities Commissions creation of an Initial Coin Offering (ICO) Consultative Network, development of a framework for members to use when dealing with investor-protection issues stemming from ICOs, and exploration into regulatory issues regarding crypto-assets platforms; and (iii) the Basel Committee on Banking Supervision’s assessment of the materiality of banks’ crypto-asset exposures, exploration of appropriate prudential treatment of those exposures, and monitoring of crypto-asset and other financial technology developments. The Financial Action Task Force is also working separately on a report to the G20 on crypto-asset concerns regarding money laundering and terrorist financing risks.
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