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 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.
Joe Scavetti of Cipperman Compliance Services recently attended the Investment Adviser Association Compliance Conference in Washington. The conference brings together senior regulatory officials and compliance professionals to address cutting-edge regulatory issues. Linked below is a more detailed summary of the meeting prepared by Joe, who would be happy to discuss with you in more detail. SEC Commissioner Hester Peirce, the conference headliner, spoke at length about the SEC’s regulatory agenda including the prospect of an SEC conduct rule. SEC officials Peter Driscoll, Director of OCIE, and Stephanie Avakian, Co-Director of Division of Enforcement, also participated, offering their views on examination and enforcement priorities. Over the course of 2 days, several panels addressed issues such as mutual funds, cybersecurity, vendor management, advertising, Form ADV, custody, and SEC exams.
IAA Compliance Conference Report 2018
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?
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.
FINRA has published a Regulatory Notice that provides guidance on the content, recordkeeping, and supervision of certain digital communications. FINRA clarifies that text and chat messages with clients must be retained as customer communications to the same extent as written or email communications. FINRA also offers guidance on when broker-dealers adopt or become entangled when using hyperlinks and other third party content. Sharing content through hyperlink will make a firm responsible for the third party content unless the third party site is dynamic, ongoing, and not influenced by the firm. However, a firm may not use a link to a third party that the “firm knows or has reason to know contains false or misleading content.” FINRA also offers guidance on the use of native advertising, mandating that such content disclose the firm’s name, any relationship, and whether mentioned products or services are offered by the firm. FINRA will allow unsolicited third party opinions posted on social media sites (e.g. “likes” on Facebook) so long as a registered representative does not subsequently endorse the third party opinion. FINRA makes clear that the guidance does not change prior rules and does not interpret SEC rules that apply to advisers.
OUR TAKE: Give FINRA credit for its ongoing regulatory guidance that reflects evolving social media and digital content. The guidance on texts, chats and hyperlinks are fairly reasonable. The challenge for compliance officers is to find emerging technologies and systems to capture the emerging content.