Up until now, the SEC has taken the position that ICOs are securities offerings, subject to the Securities Act’s registration and disclosure requirements. This no-action letter and companion guidance suggest that the SEC may back off its aggressive position and allow the digital token world to evolve organically. What is unclear is whether any ICO sponsor should go forward without a no-action letter.
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.
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 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.
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.
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?
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.