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SEC exams to focus on ICOs, cybersecurity, and AML programs
On February 7, the SEC’s Office of Compliance Inspections and Examinations (OCIE) released its 2018 Examination Priorities, which includes cryptocurrency and Initial Coin Offerings (ICOs) for the first time. According to the document, the OCIE’s 2018 priorities reflect “certain practices, products, and services that OCIE believes may present potentially heightened risk to investors and/or the integrity of the U.S. capital markets.” The document highlights five themes:
- Retail Investors. Among other retail investor priorities, OCIE states it will focus on high-risk products, including cryptocurrency and ICO markets due to their rapid growth. Exams in this area will review whether there are adequate controls and safeguards to protect against theft and whether appropriate disclosures about the risks associated with the investments are given to investors.
- Compliance and Risks in Critical Market Infrastructure. OCIE will look at important participants in the market structure, including clearing agencies, national securities exchanges, transfer agents, and entities under Regulation SCI.
- Review of Other Regulatory Bodies. OCIE intends to review the operations and controls of the Financial Industry Regulatory Authority (FINRA) and the Municipal Securities Rulemaking Board (MSRB).
- Cybersecurity. OCIE notes that the scope and severity of cybersecurity risks have increased dramatically. According to the document, examinations will continue to focus on, among other things, data loss prevention, governance and risk assessment, and vendor management.
- AML Programs. Anti-money laundering (AML) program examinations will focus on whether the regulated entities are “appropriately adapting their AML programs to address their obligations.” More specifically, OCIE will look at whether entities are filing accurate Suspicious Activity Reports (SARs) and performing appropriate customer due diligence reviews.
Market regulators discuss cryptocurrency oversight gaps during Senate Banking Committee hearing
On February 6, the Senate Committee on Banking, Housing, and Urban Affairs held a hearing entitled, “Virtual Currencies: The Oversight Role of the U.S. Securities and Exchange Commission and the U.S. Commodity Futures Trading Commission” to discuss the need for unified measures to close regulatory gaps in the cryptocurrency space. Committee Chairman Mike Crapo, R-Idaho, opened the hearing by briefly discussing the rise in interest in virtual currencies among Americans, as well as investor education and enforcement efforts undertaken by the SEC and the CFTC. Crapo commented that he was interested in learning how regulators plan to safeguard investors. Sen. Sherrod Brown (D-Ohio), ranking member of the Committee, spoke about the importance of pursuing “the unique enforcement of regulatory demands posed by virtual currencies.”
SEC Chairman Jay Clayton commented in prepared remarks that the SEC does not want to “undermine the fostering of innovation through our capital markets,” but cautioned that there are significant risks for investors when they participate in an entity’s initial coin offering (a method used to raise capital through decentralized autonomous organizations or other forms of distributed ledgers or blockchain technology) or buy and sell cryptocurrency with firms that are not compliant with securities laws. Speaking before the Committee, Clayton stated that the SEC has some oversight power in this space but supported collaborating with Congress and states on new regulations for cryptocurrency firms. “We should all come together, the federal banking regulators, CFTC, the SEC—there are states involved as well—and have a coordinated plan for dealing with the virtual currency trading market,” Clayton stressed.
In prepared remarks, CFTC Chairman Chris Giancarlo discussed different approaches to regulating distributed ledger technologies and virtual currencies. “‘Do no harm’ was unquestionably the right approach to development of the internet. Similarly, I believe that ‘do no harm’ is the right overarching approach for distributed ledger technology,” Giancarlo said. “Virtual currencies, however, likely require more attentive regulatory oversight in key areas, especially to the extent that retail investors are attracted to this space.”
Giancarlo referenced a joint op-ed in which the two chairmen discussed whether the “historic approach to the regulation of currency transactions is appropriate for the cryptocurrency markets,” and offered support for “policy efforts to revisit these frameworks and ensure they are effective and efficient for the digital era.” The chairmen also agreed that the lack of a clear definition for what cryptocurrencies are has contributed to regulatory challenges, but stressed that their agencies would continue to bring enforcement actions against fraudsters. Both the SEC and CFTC have joined a virtual currency working group formed by the Treasury Department—which also includes the Federal Reserve and the Financial Crimes Enforcement Network—to discuss cryptocurrency jurisdiction among the agencies and understand where the gaps exist.
See here for additional InfoBytes coverage on initial coin offerings and virtual currency.
SEC halts allegedly fraudulent ICO
On January 30, the Securities and Exchange Commission (SEC) announced it obtained a court order preventing an allegedly fraudulent initial coin offering (ICO) by a Dallas-based company. According to the complaint filed on January 25, the company pitched its ICO by depicting itself as a “decentralized bank” that could automatically trade in multiple cryptocurrencies and provide a variety of consumer banking products and services based on over 700 different virtual currencies. The SEC alleges that the company failed to properly register the ICO and made materially false statements in its advertisements, such as: (i) the company’s purchase of an FDIC-insured bank; and (ii) the availability of a company-branded VISA card allowing for payment of goods and services using different virtual currencies held in a checking account with the company. The company also purportedly failed to disclose the criminal background of certain executives. According to the SEC, the District Court approved an emergency asset freeze and placed the company in receivership. Among other things, the SEC is seeking a permanent injunction and the release of profits associated with the fraudulent activity, plus interest and penalties.
SEC and CFTC issue joint statement on virtual currency enforcement actions; CFTC files lawsuits alleging cryptocurrency fraud
On January 19, the SEC and the Commodity Futures Trading Commission (CFTC) issued a joint statement to reiterate the agencies’ positions on virtual currency enforcement and stress that they “will look beyond form, examine the substance of the activity and prosecute violations of the federal securities and commodities laws.” As previously discussed in InfoBytes last year (see here and here), the SEC determined that federal securities laws apply to anyone who offers and sells securities in the United States, regardless of the manner of distribution or whether dollars or virtual currencies are used to purchase the securities, while the CFTC announced that virtual currencies are commodities. Additionally, both agencies filed enforcement actions in 2017 against firms based upon fraud allegations (coverage available here and here).
Separately, on January 18, the CFTC filed lawsuits in the U.S. District Court for the Eastern District of New York against two individuals and their companies, alleging commodities law violations and fraud in the cryptocurrency market. In the first complaint, the CFTC alleged that a UK-registered company and its owner solicited cryptocurrency investments from members of the public for a commodity pool, but misrepresented the company’s trading expertise, misappropriated over $1 million of the pool’s funds, and failed to engage in the proposed investments with the pooled funds. In the second complaint, the CFTC alleged that a New York-based company and its owner operated a deceptive and fraudulent scheme in which they solicited cryptocurrency transfers in exchange for virtual currency investment advice and trading guidance, but never actually provided such advice. The CFTC further claimed the company concealed its scheme after collecting customer funds by removing its internet presence and ceasing communications with those customers. The suits seek, among other things, disgorgement of profits, civil monetary penalties, restitution, and a ban on commodities trading for the defendants.
Senate Banking Committee: The impact of cryptocurrency in AML/BSA enforcement
On January 17, the Senate Committee on Banking, Housing, and Urban Affairs held a second hearing with witnesses from the Treasury and Justice departments to further address the need to modernize and reform the Bank Secrecy Act and anti-money laundering (BSA/AML) regime. The hearing, entitled “Combating Money Laundering and Other Forms of Illicit Finance: Administration Perspectives on Reforming and Strengthening BSA Enforcement,” follows a January 9 hearing before the same Committee on related issues (see previous InfoBytes coverage here). Committee Chairman Mike Crapo, R-Idaho, opened the hearing by stating the need to understand the government’s position on “strengthening enforcement and protecting the integrity of the U.S. financial system in a new technological era,” while also recognizing the challenges technology creates for law enforcement. A primary topic of interest to the Committee was “the rise of cryptocurrencies and their potential to facilitate sanctions evasion and perhaps, other crimes.”
The first witness, Treasury’s undersecretary for terrorism and financial crimes, Sigal Mandelker (testimony), noted that money laundering related to cryptocurrencies is “an area of high focus” for Treasury, and highlighted actions taken by Treasury’s Financial Crimes Enforcement Network (FinCEN), such as the release of guidance announcing that “virtual currency exchangers and administrators” are subject to regulations under the BSA. Regulated entities, Mandelker stated, are required to file suspicious activity reports (SARs) and are subject to FinCEN and IRS examinations and enforcement actions. Mandelker further commented that Treasury is “aggressively tackling” illicit financing entering the U.S. system and elsewhere, and stressed that other countries face consequences if they fail to have an AML/Combating the Financing of Terrorism regime that meets Treasury standards.
The second witness, DOJ acting deputy assistant attorney general M. Kendall Day (testimony), informed the Committee of the recent hiring of a digital currency counsel who is responsible for ensuring prosecutors are up-to-date on the latest money-laundering threats in the digital currency field. Day also commented on recent DOJ prosecutions in this space, and emphasized the need for enhanced information sharing for law enforcement, including the benefit of deriving information from SARs.
Senate Banking Committee: Sharpen the focus of AML/BSA enforcement and oversight
On January 9, the Senate Committee on Banking, Housing, and Urban Affairs held a hearing entitled, “Combating Money Laundering and Other Forms of Illicit Finance: Opportunities to Reform and Strengthen BSA Enforcement” to discuss anti-money laundering and Bank Secrecy Act (AML/BSA) enforcement and compliance. Committee Chairman Mike Crapo (R-Idaho) opened the hearing by stating that Congress and financial regulators must examine and address “decades-old” Bank Secrecy Act and anti-money laundering requirements in order “to sharpen the focus, sustainability and enforcement of a modernized, more efficient U.S. counter-threat-finance architecture.” During the hearing, the Committee stressed the need to move towards a more targeted, strengthened AML framework so that banks, law enforcement, and regulators can focus on specific threats such as the financing of terrorism and sanctions evasions.
The three witnesses offered numerous insights related to reforming AML/BSA enforcement and regulatory structures, including: (i) establishing an approach that would utilize and track intelligence and analysis rather than focusing primarily on quantifiable metrics; (ii) increasing inter-agency coordination and improving information sharing between financial institutions and regulators, and among financial institutions themselves; (iii) recognizing the importance of law enforcement participation, specifically related to the sharing of suspicious activity reports; (iv) encouraging the participation of entities outside of the banking sector, such as persons involved in real estate or those acting as proxies for financial system access; (v) supporting beneficial ownership legislation for companies formed in the United States; and (v) understanding the ways in which financial institutions are addressing the anonymity of cryptocurrencies and blockchain technology. The witnesses were:
FINRA releases 2018 regulatory and examinations priorities letter
On January 8, the Financial Industry Regulatory Authority (FINRA) published its Annual Regulatory and Examination Priorities Letter (2018 Letter), which focused on several broad issues within the securities industry, including improving the examination program to “implement a risk-based framework designed to better align examination resources to the risk profile of [] member firms.” As previously covered in InfoBytes, last July FINRA360 (a comprehensive self-evaluation and organizational improvement initiative) prompted the organization to announce plans currently underway to enhance operations by consolidating its existing enforcement teams into a single unit. In the 2018 Letter, FINRA announced ongoing efforts to work with member firms to understand the risks and benefits of fintech innovation such as blockchain technology, as well as the impact initial coin offerings (ICOs) and digital currencies have on broker-dealers.
Additional areas of regulatory and examination focus for FINRA in 2018 will include: (i) fraudulent activities and suspicious activity report filing requirements; (ii) business continuity planning; (iii) protection and verification of customer assets, including whether firms have implemented adequate controls and supervision methods along with measuring the effectiveness of cybersecurity programs; (iv) anti-money laundering monitoring and surveillance resources and policies and procedures; and (v) the role firms and other registered representatives play when effecting transactions in cryptocurrencies and ICOs—specifically with regard to the supervisory, compliance and operational infrastructure firms implement to “ensure compliance with relevant federal securities laws and regulations and FINRA rules.”
SEC Obtains Emergency Court Order Against Canadian Firm for Allegedly Violating Federal Securities Law; Halts Initial Coin Offering
On December 4, the SEC announced it had obtained an emergency court order to freeze the assets of a Canadian company and the company’s founders (Defendants) and block Defendants’ ability to continue to raise funds through an initial coin offering (ICO). At the time the order was issued, the ICO had raised $15 million since August by “promising investors returns of 1,354% in under 29 days.” This is the first enforcement action taken by the SEC’s recently established Cyber Unit, whose focus includes distributed ledger technology and initial coin offering violations. (See previous InfoBytes Cyber Unit coverage here.)
According to a complaint filed December 1 in the U.S. District Court for the Eastern District of New York, Defendants allegedly violated the anti-fraud and registration provisions of U.S. federal securities laws by making a series of materially false and misleading statements when marketing and selling securities as digital tokens/cryptocurrencies to obtain investor funds. From August to the present, Defendants purportedly raised $15 million through the ICO, and made false representations including, among other things, that: (i) the firm consisted of large teams of experts across the globe, and (ii) investors would receive certain promised returns (1,354% in less than a month) on investments if all tokens were sold. Further, Defendants allegedly failed to disclose (i) that a portion of the proceeds from the ICO funds would pay personal expenses, and (ii) that the company’s principal executive was “a known recidivist securities law violator in Canada.” The SEC seeks relief in the form of permanent injunctions, monetary penalties and interest, and an “officer-and-director bar and a bar from offering digital securities” against the company’s founders.
SEC Chairman Discusses Corporate Governance, States Enhanced Transparency Can Help Prevent Fraud, and Reveals First-Ever National Database of Barred Brokers and Advisors
On November 8, the Chairman of the SEC, Jay Clayton, spoke before the Practising Law Institute’s annual institute on securities regulation to discuss the role of corporate governance and how enhanced transparency can help prevent fraud. Clayton stated that the SEC would be streamlining and shortening its near-term agenda in an effort to increase transparency and accountability, and that the SEC also would apply this approach to its longer-term strategic plans as well.
Clayton also commented on approaches to mitigate “misconduct” before an enforcement action would be required. Specifically, Clayton noted, “[l]ooking back at enforcement actions, a common theme emerges – where opacity exists, bad behavior tends to follow.” Clayton highlighted the following areas in which opacity may exist: (i) disclosures involving “hidden or inappropriate fees”; (ii) poor recordkeeping and lack of reliable information related to penny stocks; (iii) transaction processing related to unregistered securities; (iv) online platforms that manage initial coin offerings (ICOs); and (v) investor education.
Concerning ICOs, Clayton commented that because “[t]here is a distinct lack of information about many online platforms that list and trade virtual coins or tokens offered and sold in . . . ICOs . . ., [t]rading of tokens on these platforms is susceptible to price manipulation and other fraudulent trading practices.” The SEC proposed enhanced clarity when listing tokens on these types of platforms, assigning value to tokens, and examining measures designed to protect investors and market integrity.
Clayton further revealed that the SEC was creating a website that would publish, among other things, a searchable database of those individuals who have been barred or suspended as a result of federal securities law violations. Clayton noted that this database would be “intended to make the prior actions of repeat offenders and fraudsters more visible to investors” and could be “particularly valuable when bad actors have shifted from the registered space for investment advisers and broker-dealers to the unregistered space.”
CFTC Issues Primer on Virtual Currencies, Claims Certain Virtual Tokens Fall Under Its Oversight
On October 17, the U.S. Commodity Futures Trading Commission (CFTC) announced the release of “A CFTC Primer on Virtual Currencies” (Primer) issued by its LabCFTC division. As previously discussed in Infobytes, the LabCFTC initiative rolled out in May of this year to engage innovators in the financial technology industry to promote responsible fintech innovation within regulated CFTC markets. In this Primer—a first in a series—the CFTC discusses potential use-cases for virtual currencies and outlines the agency’s role and oversight of virtual currencies. The Primer also highlights the risks associated with virtual currencies, such as (i) the susceptibility of “digital wallets” to cybersecurity hacks; (ii) inadequate safeguards and other customer protection related systems on virtual currency exchanges; and (iii) the susceptibility of virtual currencies to Ponzi schemes and other types of frauds.
The CFTC noted that there’s no inconsistency between the SEC’s analysis that Initial Coin Offerings or Token Sales may be subject to federal securities law (see previous InfoBytes coverage here) and CFTC’s determination that virtual currencies are commodities and virtual tokens “may be commodities or derivatives contracts, depending on the particular facts and circumstances.” Last month, as discussed in InfoBytes, the CFTC also filed its first-ever antifraud enforcement action for activities involving Bitcoin investment solicitations.