A federal judge has ruled that an initial coin offering may not constitute an offering of securities. In rejecting the SEC’s request for a preliminary injunction against an ICO, Judge Gonzalo Curiel of the Southern District of California, opined that the SEC failed to present sufficient facts to satisfy the Howey test requiring an investment of money in a common enterprise with an expectation of profit produced by the efforts of others. Faced with conflicting interpretations of how the ICO operated, the Court denied the preliminary injunction because of genuine disputes about material facts.
The significance of this decision is that a court is requiring the SEC to factually prove the three prongs of the Howey test rather than simply accept the SEC’s position that digital tokens are securities. If the SEC fails to prove its case and digital tokens are not securities, the SEC will not have the legal authority to regulate ICOs.
The SEC ordered two initial coin offerings to offer investors rescission and pay a $250,000 fine for failing to register the offerings under the securities laws. These cases represent the first time that the SEC has imposed civil penalties solely for ICO securities offering registration violations. One of the respondents raised $15 million by selling digital tokens intended to create a new digital coin ecosystem related to advertising and mobile phones. The other respondent raised $12 Million to create a blockchain technology for the emerging cannabis industry. The SEC maintains that the digital tokens are “securities” under the Howey test and, therefore, the offerings violated the registration requirements of the 1933 and 1934 Acts. Both respondents undertook to register the offerings.
Given the SEC’s concerns about disclosure and compliance for ICOs, it will be interesting to see the extent of disclosure required in the promised registration statements.
The SEC fined and censured the founder of a digital token trading platform that failed to register as a national securities exchange. The SEC argued that, under SEC v. Howey, the tokens traded included securities because the purchasers of tokens “invested money with a reasonable expectation of profits, including through the increased value of their investments in secondary trading, based on the managerial efforts of others.” The token exchange allowed buyers and sellers to view pairs available for trading and a display of the top 500 bids and allowed users to enter buy and sell orders.
We expect a well-funded party will ultimately challenge the SEC in the courts about whether digital tokens are securities subject to SEC supervision. However, until a court decides otherwise, those that trade in digital tokens and those that facilitate trading must register as broker-dealers or as exchanges.
The SEC suspended trading of a public company that issued press releases claiming SEC approval of its cryptocurrency products. The company’s press releases advertised that it had partnered with an SEC qualified custodian for cryptocurrency transactions and that it was conducting an SEC-registered token offering. The SEC’s Cyber Unit Chief warned that the SEC “does not endorse or qualify custodians for cryptocurrency.”
Back in January, the SEC raised several regulatory questions around ICO offerings and notified the industry that it would not approve crypto-offerings until the issues were adequately addressed. Any efforts to suggest otherwise will draw the attention of the Enforcement Division’s Crypto Unit.
The manager of a crypto hedge fund offered its investors rescission and agreed to pay a $200,000 fine for failing to comply with the securities. The SEC argues that the fund, which invested in digital assets, was “engaged in the business of investing, holding, and trading certain digital assets that were investment securities.” Consequently, the offering, which did not comply with Regulation D’s private offering safe harbors, should have been registered under the Investment Company Act. The SEC charges violations of the registration provisions of the Securities Act and the Investment Company Act as well as the antifraud rules. This case is the SEC’s first enforcement action against a crypto hedge fund manager for failing to register under the Investment Company Act.
OUR TAKE: Most significant is the SEC Enforcement Division taking the position that a fund that invests in digital assets is subject to the securities laws. It remains to be seen whether others will challenge that position in the courts.
Bridget Garcia of Cipperman Compliance Services recently attended the Futures Industry Association Law and Compliance Conference in Washington. The well-attended event addressed cryptocurrencies and related regulation, a major issue of interest to the industry. Panels discussed the evolution and purpose of cryptocurrencies and how the CFTC, SEC and FINRA will carve up regulatory responsibilities. Moving onto more tactical matters, one panel discussed regulatory hot topics, including AML and GDPR, and another panel tackled CCO responsibilities. Day 3 focused heavily on swaps and derivatives. Feel free to contact Bridget if you want more information.
Link to conference summary
The SEC’s Director of Corporation Finance, William Hinman, recently opined that cryptocurrencies themselves are not securities subject to SEC oversight, although undertakings operated by a central control group and targeted to passive third parties would constitute a securities offering. Absent a “central enterprise” such that the digital asset is sold only to be used to purchase a good or service available through the network on which it was created, Mr. Hinman would not apply the securities laws. Factors that transform an enterprise into an offering of securities include (i) a central group that promotes the offering and benefits and expends assets/effort to increase the value; (ii) the raising of funds in excess of what is necessary to establish a functional network; (iii) purchasers that seek a return in excess of the current market value; and (iv) a sales effort directed to the general public rather than users. Mr. Hinman announced that the Division would be willing to offer promoters more formal interpretive or no-action guidance to ensure legal comfort.
OUR TAKE: Mr. Hinman offers practical guidance and some clarity on how to apply decades-old precedent to modern cryptocurrency networks and offerings. We expect more guidance in the coming months from the other SEC divisions.
Today, we offer our “Friday List,” an occasional feature summarizing a topic significant to investment management professionals interested in regulatory issues. Our Friday Lists are an expanded “Our Take” on a particular subject, offering our unique (and sometimes controversial) perspective on an industry topic.
Last week, the SEC’s Division of Investment Management asked sponsors to refrain from initiating registrations for funds investing in cryptocurrencies and related products. Dalia Blass, the Division Director, cited “significant outstanding questions” about how such funds could comply with applicable laws and regulations. In today’s Friday List, we describe the top 10 regulatory concerns raised by the Division of Investment Management. Despite these concerns, we believe that the SEC and the industry will work through these issues and develop rules and best practices that will ensure the growth of this market in a manner that engenders investor confidence.
Top 10 Cryptocurrency Fund Regulatory Concerns
- Valuation: The SEC asks whether funds could obtain sufficient information to properly value fund assets pursuant to current accounting rules especially given the “nascent state and current trading volume” in the futures markets.
- Liquidity: Could funds reduce crypto-assets to cash so as to meet daily redemption requests? How would funds classify assets under the SEC’s new liquidity rule (22e-4)?
- Custody: The SEC questions how a fund custodian could validate the existence and ownership of cryptocurrency assets, and how funds would address physical security where applicable.
- ETF Creation: Will the creation unit process operate in a way that ensures that funds and authorized participants limit arbitrage opportunities that harm investors?
- Volatility: The limited history and volume of the cryptocurrency markets could negatively impact fund operations and affect investors.
- Lack of regulation: Neither cryptocurrency markets nor providers/issuers are subject to prudential regulation.
- Market manipulation: The SEC cites Chairman Clayton’s concerns over market manipulation and potential fraud.
- Cybersecurity: Could a potential hack threaten ownership interests and valuation? What safeguards are in place?
- Disclosure: How would fund sponsors ensure sufficient risk disclosure and transparency in fund prospectuses and other shareholder communications?
- Suitability: How will broker-dealers and advisers ensure their suitability and fiduciary obligations when recommending crypto-funds to retail investors?
The SEC’s Division of Investment Management sent a letter to the ICI and SIFMA listing the “significant outstanding questions” concerning how proposed registered funds investing in cryptocurrencies and related products would satisfy the Investment Company Act. The letter, signed by Division Director Dalia Blass, warned potential fund sponsors against initiating fund registrations until these questions “can be addressed satisfactorily.” The letter questions how funds would value cryptocurrencies and related products given their volatility and lack of regulation. The Division also questions liquidity and whether funds could meet daily redemption requests. The letter also raises custody concerns, asking how funds could “validate existence, exclusive ownership, and software functionality.” ETFs pose additional questions related to authorized participant and arbitrage processes. The letter also asks about distribution and fiduciary duty. The Division expressed its willingness to “engage in dialogue with sponsors regarding the potential development of these funds.”
OUR TAKE: We believe that both the industry and the SEC have vested interests in coming to an agreement to allow cryptocurrency offerings. The industry should welcome prudent regulation, which gives investors the type of confidence that made mutual funds so successful. The SEC should get out in front of this issue to become the regulator of choice rather than cede its regulatory authority to offshore, non-U.S., and private markets.
NASAA and the SEC warned investors about the risks of investing in cryptocurrency-linked investment products. The President of NASAA (the association of state securities regulators) warned, “Cryptocurrencies and investments tied to them are high-risk products with an unproven track record and high price volatility. Combined with a high risk of fraud, investing in cryptocurrencies is not for the faint of heart.” NASAA further highlighted the risks of cryptocurrency investments including minimal regulatory oversight, the possibility of cybersecurity breaches, lack of insurance, high volatility, and reliance on unproven companies. The SEC commended NASAA’s statement, stressing that cryptocurrencies, “lack many important characteristics of traditional currencies, including sovereign backing and responsibility, and now are being promoted more as investment opportunities than efficient mediums for exchange.”
OUR TAKE: We predicted (not very long ago) that the regulators will pursue regulation of cryptocurrency offerings. This may not be bad for this emerging industry in the long term. After all, significant regulation made mutual funds the most popular investment vehicle of the last 100 years.