InfoBytes Blog
Filter
Subscribe to our InfoBytes Blog weekly newsletter and other publications for news affecting the financial services industry.
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[.]’”
Court holds SEC has not proven pre-ICO cryptocurrency is a “security”
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.
Two ICO issuers settle SEC charges for securities offering registration violations
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.
Colorado Division of Securities issues cease-and-desist orders against ICOs
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.
SEC announces first settlement with a digital currency exchange
On November 8, the SEC announced its first enforcement action settlement with a digital currency platform for allegedly operating as an unregistered national securities exchange. According to the cease-and-desist order, the founder of the digital currency exchange, who has since sold the exchange to foreign buyers, allegedly violated federal securities laws by providing an online platform for secondary market trading of digital assets, including ERC20 tokens, without registering with the Commission or operating pursuant to a registration exemption. ERC20 tokens are digital assets issued and distributed on the Ethereum Blockchain using the ERC20 protocol, which, according to the SEC, is the standard coding protocol currently used by a significant majority of issuers in initial coin offerings. The order emphasizes that 92 percent of the trades on the exchange took place after the SEC released its Report of Investigation Pursuant To Section 21(a) Of The Securities Exchange Act of 1934: The DAO (the DAO Report) in July 2017, advising that non-exempt digital currency exchanges must register with the Commission. Without admitting or denying the findings, the founder agreed to pay $300,000 in disgorgement plus interest and a $75,000 penalty.
Arizona approves two more participants in fintech sandbox program
On November 1, the Arizona Attorney General announced the approval of two more participants in the state’s fintech sandbox program. The first company, which is based in New York, will test a savings and credit product, enabling Arizona consumers to obtain a small line of credit aimed at providing overdraft protection. If a consumer agrees to a repayment plan recommended by the company’s proprietary technology, the APR may be as low at 12 percent; if a consumer adopts a different repayment plan, the line of credit will have a standard APR of 15.99 percent. The company intends to report transactions under the payment plan to national credit bureaus to enable the building of credit histories. The second company, an Arizona-based non-profit, will test a lending product using proprietary blockchain technology, which has an APR cap of 20 percent.
As previously covered by InfoBytes, the Arizona governor signed legislation in March creating the first state sandbox program for companies to test innovative financial products or services without certain regulatory requirements. In October, the Attorney General announced the first sandbox participant, a mobile platform company (InfoBytes coverage available here).
FATF updates standards to prevent misuse of virtual assets; reviews progress on jurisdictions with AML/CFT deficiencies
On October 19, the Financial Action Task Force (FATF) issued a statement urging all countries to take measures to prevent virtual assets and cryptocurrencies from being used to finance crime and terrorism. FATF updated The FATF Recommendations to add new definitions for “virtual assets” and “virtual asset service providers” and to clarify how the recommendations apply to financial activities involving virtual assets and cryptocurrencies. FATF also stated that virtual asset service providers are subject to Anti-Money Laundering/Combating the Financing of Terrorism (AML/CFT) regulations, which require conducting customer due diligence, such as ongoing monitoring, record-keeping, and suspicious transaction reporting, and commented that virtual asset service providers should be licensed or registered and will be subject to compliance monitoring. However, FATF noted that its recommendations “require monitoring or supervision only for purposes of AML/CFT, and do not imply that virtual asset service providers are (or should be) subject to stability or consumer/investor protection safeguards.”
The same day, FATF announced that several countries made “high-level political commitment[s]” to address AML/CFT strategic deficiencies through action plans developed to strengthen compliance with FATF standards. These jurisdictions are the Bahamas, Botswana, Ethiopia, Ghana, Pakistan, Serbia, Sri Lanka, Syria, Trinidad and Tobago, Tunisia, and Yemen. FATF also issued a public statement calling for continued counter-measures against the Democratic People's Republic of Korea due to significant AML/CFT deficiencies and the threats posed to the integrity of the international financial system, and enhanced due diligence measures with respect to Iran. However, FATF will continue its suspension of counter-measures due to Iran’s political commitment to address its strategic AML/CFT deficiencies.
SEC launches FinHub to facilitate fintech innovation
On October 18, the SEC announced the launch of its Strategic Hub for Innovation and Financial Technology (FinHub). According to the SEC, FinHub will assist in facilitating public engagement on fintech-related topics, including blockchain/distributed ledger technology, digital marketplace financing, automated investment advice, and artificial intelligence/machine learning. Through FinHub, industry participants and the public will have the opportunity to engage directly with the SEC to discuss and test innovative ideas and technological developments. FinHub will also act as a clearinghouse for SEC staff to access and disseminate fintech-related information throughout the agency, and will “[s]erve as a liaison to other domestic and international regulators regarding emerging technologies in financial, regulatory, and supervisory systems.”
“FinHub provides a central point of focus for our efforts to monitor and engage on innovations in the securities markets that hold promise, but which also require a flexible, prompt regulatory response to execute our mission,” SEC Chairman Jay Clayton announced.
Financial Stability Board report: Crypto-assets not yet posing material risk to financial stability
On October 10, the Financial Stability Board (FSB) published a report, which asserts that although “crypto-assets do not pose a material risk to global financial stability at this time,” there may be implications for financial stability in the future as market developments evolve. The newest report, “Crypto-asset markets: Potential channels for future financial stability implications,” follows a July report discussing the FSB’s framework for monitoring and assessing vulnerabilities in the financial system resulting from developments in the crypto-asset markets. (See previous InfoBytes coverage here.) According to the October report, the FSB conducted an assessment which considered the primary risks present in crypto-assets and their markets, such as “low liquidity, the use of leverage, market risks from volatility, and operational risks,” and determined that, “[b]ased on these features, crypto-assets lack the key attributes of sovereign currencies and do not serve as a common means of payment, a stable store of value, or a mainstream unit of account.” However, the October report discussed challenges to assessing and monitoring potential risks and commented on the following implications that may arise from the evolving use of crypto-assets: (i) reputational risks to financial institutions and their regulators; (ii) risks from direct or indirect exposures of financial institutions; (iii) risks resulting from the use of crypto-assets in payments and settlements; and (iv) risks from market capitalization and wealth effects.
California to appoint “blockchain” working group
On September 28, the California governor signed AB 2658, which requires the Secretary of the Government Operations Agency to appoint a blockchain working group by July 1, 2019. (The act defines blockchain as “a mathematically secured, chronological, and decentralized ledger or database.”) The working group is charged with evaluating, among other things, (i) the risks and benefits associated with the use of blockchain by state government and California-based businesses; (ii) the legal implications of the use of blockchain; and (iv) best practices for enabling blockchain technology to benefit the state and its businesses and residents. The act, which has a sunset date of January 1, 2022, requires the working group to provide a report to the legislature by July 1, 2020.