2/25/19 - Promontory Currents: ICO or IC-No? SEC Persuades Court to Reverse Course in Case Against ICO Issuer
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2/25/19 - Promontory Currents: ICO or IC-No? SEC Persuades Court to Reverse Course in Case Against ICO Issuer

By Jacob Lesser and Chris Seigle

As interest in cryptocurrencies has grown, the Securities and Exchange Commission has gone to great lengths to protect investors from digital assets that take the form of unregistered securities. Earlier this month, the SEC argued successfully for a preliminary injunction against a digital-asset firm’s initial coin offering.1 A federal court reversed its earlier ruling in the firm’s favor and issued a stark warning not only to entities considering an ICO, but to anyone participating in the ICO process, including brokers, asset managers, and trading platforms.

The SEC’s Case and the Court’s Reversal

In March 2018, a firm that began presales of a digital asset made a number of claims that the SEC considered fraudulent, including:

  • Its ICO was registered with, and approved by, the SEC.
  • Its ICO was approved or endorsed by the Commodities Futures Trading Commission and the National Futures Association.
  • The firm “partnered with,” and was audited by, a Big Four accounting firm.
  • The firm was the “First Licensed and Regulated Tokenized Crypto Currency Exchange and Index Fund.”2  

The firm also created a fictitious regulatory agency, the “Blockchain Exchange Commission,” complete with a seal, logo, and mission statement nearly identical to those of the SEC.3  

In October 2018, the SEC obtained a temporary restraining order in federal court to stop the ICO. Two months later, however, the court denied the SEC’s request for a preliminary injunction. In siding with the firm, the court appeared open to arguments that some of the digital asset’s “investors” were merely testing the firm’s platform, and that others had not invested in the asset but, rather, had simply made personal loans to the firm’s founder and chief financial officer.

However, on Feb. 14, 2019, the court changed course after the SEC presented a more straightforward legal argument: By promoting the ICO through a white paper posted online — a common step in the ICO process — the firm had offered the digital asset for sale, regardless of whether any transaction had been completed.4 Moreover, the court found that the asset met the legal definition of a security because the white paper and other online materials promoted it as a passive investment in which raised funds would be pooled and profits would be shared. After concluding that there was a reasonable chance of future violations, the court issued an injunction, effectively blocking the ICO.

Implications for Digital-Asset Markets

While this case involves particularly egregious conduct, it serves as an important reminder that the SEC generally views tokens issued through ICOs as securities. As a result, market participants risk running afoul of federal securities laws, including registration provisions, when playing a role in the issuance and trading of such assets — even in the absence of any conduct that might be viewed as fraudulent. Of course, any potential misstatements or omissions in promotional materials will amplify the risks that the SEC will take notice and that any eventual penalties will be more serious.

These regulatory risks are not limited to ICO issuers. The SEC has also stated that an entity that facilitates the issuance and secondary trading of digital assets may be acting as a broker-dealer that must register with the commission and become a member of a self-regulatory organization, typically the Financial Industry Regulatory Authority.5 Such an entity would also need to comply with the legal and regulatory requirements governing broker-dealers’ marketplace conduct. Likewise, a trading platform geared toward digital assets may need to register as a national securities exchange pursuant to the Securities Exchange Act of 1934 or qualify for a valid exemption, such as by operating as an alternative trading system in compliance with Regulation ATS (alternative trading system).6  

Asset managers should also take notice. In September 2018, the SEC found that a hedge fund formed to invest in digital assets had failed to properly register as an investment company, violating the Investment Company Act of 1940.7  

Finally, the SEC has cautioned that any market participant that accepts cryptocurrencies such as bitcoin or ether to facilitate the issuance or trading of digital tokens risks noncompliance with anti-money-laundering and know-your-customer obligations.8  

Cryptocurrencies and digital tokens are innovative vehicles to create and transfer value that are pushing industry stakeholders to rethink fundamental aspects of the financial system. As these technologies continue to develop, however, many products and players remain subject to the same standards that apply to traditional products and services. Therefore, while this new frontier offers great promise, it also presents risks — not only to investors, but also to market participants. As digital products become increasingly widespread, regulation of the digital-finance space likely will increase markedly, perhaps one day to include a real-life “Blockchain Exchange Commission.”

Authors

Jacob Lesser is a director, and Chris Seigle is a principal, in Promontory’s Washington office.


FOOTNOTES

1. Case No. 18CV2287-GPB(BLM), U.S. District Court for the Southern District of California (Feb. 14, 2019).

2. Ibid.

3. Ibid.

4. Section 17(a) of the Securities Act of 1933 prohibits fraud in the offer or sale of securities.

5. Jay Clayton, “Statement on Cryptocurrencies and Initial Coin Offerings,” Securities and Exchange Commission (Dec. 11, 2017).

6. “Statement on Digital Asset Securities Issuance and Trading,” SEC (Nov. 16, 2018).

7. “Administrative Proceeding File No. 3-18740,” SEC (Sept. 11, 2018).

8. Clayton, “Statement on Cryptocurrencies.”