On February 28th, the Wall Street Journal reported that the SEC delivered “dozens” of subpoenas to cryptocurrency companies https://www.wsj.com/articles/sec-launches-cryptocurrency-probe-1519856266. Some report that 80 or more such companies were served. The warning signs are over; the gauntlet is thrown. It would be fervently delusional to think indiscriminate crowdfunding of crypto “tokens” will continue without regulator scrutiny—at least in the U.S.. The SEC is on the hunt for unlawful sales of securities and unlawful crypto exchanges. Crypto companies caught in this roundup may face an estimable financing retrofit, if they are permitted to do so.
The SEC is also taking aim at the gatekeepers, the lawyers, who have enabled this process.
In 2017, the words bitcoin, blockchain and crypto anything were the sexiest topics in finance–and around the water cooler. In 2018, those words will likely be among the sexiest topics in law.
It is astonishing that crypto players got away with it as long as they did. Some crypto companies raised millions in minutes, distributing White Papers (purportedly containing all relevant company info) to the online public that are short, grammatically unsound, and rife with spelling errors. That alone is unacceptable. To regulators, however, depending on the nature of the offering, it is more than unacceptable. First a couple of clarifications.
Relevant Terminology Clarification: Most Cryptocurrencies are not Cryptocurrencies
Most so-called “cryptocurrencies” are not cryptocurrencies at all. Most are profit-seeking, blockchain-based, cryptographically protected companies that raise capital by selling “tokens” online though a crowdfunding platform to any and everyone. Legally, all blockchain-based, cryptographically protected digital efforts should be called crypto assets. Under the rubric of crypto assets, three general categories can be identified: cryptocurrencies, utility tokens, and crypto securities. While the legal test that defines a crypto security includes 4 indicia, substantively, the key test is whether the particular crypto asset has income potential. Briefly, the income characteristics of these categories are as follows:
Cryptocurrency: Bitcoin is a digital currency. It largely satisfies the three indicia constituting a currency: medium of exchange; unit of account; and store of value. It is nothing more than a cryptographically protected digital transaction unit. Given existing protocols, you will never receive an income from holding Bitcoin.
Utility Tokens: Like Bitcoin, utility “tokens” will never produce an income. They are a sort of entry fee to play, but you will never earn money from them.
Crypto Security (Profit Producing Token): Here, profit is the motive. If we remove the new-tech language from the definition above we get the following:
“profit-seeking, blockchain-based, cryptographically protected companies that raise capital by selling tokens to the public at large through an online crowdfunding platform.”
This definition should sound familiar if you change the word tokens with shares. In the eyes of regulators, this is nothing more than a public offering of stock; and that requires a prospectus, or an exemption therefrom.
In the Munchee Order, https://www.sec.gov/litigation/admin/2017/33-10445.pdf the SEC expanded on the definition of a security. The Howey test talks of “a reasonable expectation of profits”, and that is usually associated with income. The SEC widened the definition of profit by linking it to an expectation of investment or capital gain. This quasi-judicial decision potentially and importantly added to the current jurisprudence as follows: if a company promotes the capital appreciation of its tokens through its white paper, advertising, or use of funds, and this engenders an expectation in token buyers (investors) that the token will appreciate in value, then all else being equal, the regulators may find the token is a security. That is despite no possibility of income from the token. While this notion was anticipated, the fact that it is contained in an SEC order that relates directly to crypto assets is important. Therefore, an otherwise utility token that promotes appreciation in their token, combined with an accompanying expectation from investors, may be found to be a security.
Securities regulators do not have substantive issuance concerns with cryptocurrencies or utility tokens, properly defined, and marketed as such. Though SEC Chair Clayton tends to believe pure utility tokens are tantamount to unicorns. However, those crypto asset companies that promote an expectation of profit (income and/or capital gain) are likely securities, and they fall squarely under the jurisdiction of securities regulators like any other security.
Securities regulators’ raison d’etre is to protect the public from all activities related to securities. It is their job to locate and sanction those entities, issuing, trading, or exchanging (e.g. NYSE) securities unlawfully.
Few crypto assets are cryptocurrencies or utility tokens; most are profit-seekers as defined above. Therein lies the rub.
Warning Shots and The Subpoenas
Over the past year regulators have fired warning shots at crypto issuers. See a previous post http://www.bsatlaw.com/icos-looking-float-crypto-lawtoday/. The July 25th, 2017 DAO decision should have curtailed crypto security issuers. https://www.sec.gov/news/press-release/2017-131. The DOA release, the Munchee Order, SEC releases, warnings by Jay Clayton etc. were relatively ineffectual. These events and words got industry people talking; but many crypto security sellers ignored the warnings. The frenzy to float an issue and raise vast amounts of capital was seemingly too intoxicating. Sellers were blind, brazen, benighted—pick an adjective. In their defence—which is not a defence–it is hard to choke down significant legal and operational costs to step into the compliant light when everybody else ignores the call to compliance. Avoiding compliance and sticking with the crowd is cheap and quick. Nonetheless, most players in this game knew or ought to have know that a whirlwind crowdfund offering to the public was unlawful. To avoid regulators, many crypto security companies dressed up white papers to masquerade as pure utility tokens, when they clearly were not. And, according to SEC head, Jay Clayton, the securities bar (securities lawyers) in the U.S. are on notice. Inevitably, those law firms that advised crypto companies inappropriately or negligently will be called out and questioned, if not sanctioned.
Regulator intervention was inevitable
If it be not now, ‘tis not to come. If it be not to come, it will be now. If it be not now, yet it will come—the readiness is all.” Hamlet: Act 5, Scene 2
The choice was a subpoena. A subpoena compels attendance to a hearing. The testimony is generally under oath. Failure to respond to a subpoena can result in punishment. Fines and imprisonment for contempt (unlikely) are possible. The point is that this exercise is serious and the SEC will get information. Bloomberg reported that this round of subpoenas were aimed at fraud. https://www.bloomberg.com/news/articles/2018-03-01/sec-is-said-to-issue-subpoenas-in-hunt-for-fraudulent-icos I believe a far wider net is cast.
The SEC, and all securities regulators, are looking for fraudulent issues and instances of misrepresentation. They will be on the prowl for those; but more likely the SEC is prowling for unlawful crypto security issuers posing as cryptocurrency/utility tokens. After all, this is a new exploding area of fund-raising that has avoided all regulator scrutiny. Despite there being an estimated 1,600 crypto assets out there, few, or none, have registered with the SEC. Jay Clayton stated that he has never seen a “utility” crypto. The clear inference: there are crypto assets that are securities and they have avoided lawful registration with regulators. In addition, there are crypto exchanges that may be exchanging crypto securities without proper registration.
The first step is to get information. The paramount goal is to implement a legal structure for the issuance of crypto assets or enterprises that is seamlessly consistent with current securities law and regulation. The subpoenas may relate to charges; there may be hearings, reviews and court cases as we enter this stage of the crypto crucible.
The SEC has telegraphed that they will follow the Howey test to decide if a token issue is de facto a security issue. In a previous article, I outline the legal test. The SEC used the Howey test in evaluating the DAO, supra.
Among other things, it is certain that the SEC will be collecting the following indicia:
1. Was there an investment? In addition, the SEC will look at the characteristics of the individuals or companies investing (friends, family, indiscriminate passive crowdfunding etc.).
2. The business. Is it a business that has the potential to make and distribute profit; and/or is it built on expectation of capital gains?
3. Do the investors substantively contribute to management and decision-making?
It is likely that issues related to money laundering and terrorism funding will be raised. Regulators will be profoundly interested in what issuers are doing to that end. They will want to see due diligence measures that satisfy “know your client” and “suitability” requirements.
Reining in the Beast
Regulators are attempting to rein in the beast. The speculative froth is news-worthy; the proliferation of crypto asset companies and the funds raised in 2017 was spectacular. The rage to create and sell tokens combined with public rage to buy them in an unregulated environment could not last. The comeuppance was inevitable. Profit-seeking technologically abstruse, blockchain-based, cryptographically protected, securities (token/shares) were being sold to the masses who barely understood them. Investor safety and regulatory order is required.
Those companies with subpoenas will expose what they have or have not done. That will be juxtaposed with what they should have done to be legally compliant. If these companies are found to have unlawfully issued securities, the SEC will have to right the wrong, level the playing field, and institute a defensible legal structure going forward. It is unlikely that the SEC will forgive issuers or in some way “grandfather” their non-compliance as acceptable. Regulators will, however, balance relevant interests going forward.
As mentioned above, regulators are in the business of protecting investors, but they are also committed to facilitating (not stifling) new methods of finance and new asset classes. Presumably, SEC decisions will adhere to these principles as they collect information on the acts and omissions of crypto security companies. SEC actions or charges will adhere to the law and these principles.
A continuum of misdeeds will emerge. It is conceivable that flagrant, knowing unlawfulness may result in return of investor funds and significant sanctions against the owners of the crypto security company. Some misdeeds may find their way to the courts; some may attract SEC sanctions. Some misdeeds may indeed by criminal. Securities regulators have broad powers and will exercise them.
What may happen, excepting fraud and other egregious misdeeds, is that the SEC will force compliance on unlawful issuers. If, as a finding of fact, the SEC finds a crypto asset is a security, the issuer will have to settle any sanctions or go to court. If there is a settlement, crypto security companies will likely be permitted to go back and fix the unlawful acts or omissions. The unlawful acts or omissions could be a myriad. Fixes will bring out the full panoply of investor protections and funding options under securities law. Here are a couple of general examples.
If the funding was an indiscriminate crowdfunding exercise to the world, that offering is tantamount to a public offering and will therefore require a prospectus through an investment dealer. If the issuer does not want to incur the expense of a prospectus, it may apply for an exemption(s). Exemptions are several, and they all carry specific rules.
Unlawful crypto asset exchanges are also in the line of fire. On March 7, the SEC issued a public statement on crypto assets trading on online platforms. https://www.sec.gov/news/public-statement/enforcement-tm-statement-potentially-unlawful-online-platforms-trading These platforms promote the buying and selling of digital assets. The SEC makes clear that if any of the exchange traded crypto assets are “securities” then that exchange is operating unlawfully. They write,
If a platform offers trading of digital assets that are securities and operates as an “exchange,” as defined by the federal securities laws, then the platform must register with the SEC as a national securities exchange or be exempt from registration. The federal regulatory framework governing registered national securities exchanges and exempt markets is designed to protect investors and prevent against fraudulent and manipulative trading practices.
…
To get the protections offered by the federal securities laws and SEC oversight when trading digital assets that are securities, investors should use a platform or entity registered with the SEC, such as a national securities exchange, alternative trading system (“ATS”), or broker-dealer.
If a trading platform (exchange) is registered with the regulators, enforceable protections are necessarily in place.
Again, the regulators are after entities that are selling, dealing, or trading in crypto securities. On February 21, the SEC charged John Mo and Bitfunder with “operating an unregistered securities exchange and defrauding users of that exchange. The SEC also charged the operator with making false and misleading statements in connection with an unregistered offering of securities.” https://www.sec.gov/news/press-release/2018-23
Becoming Lawful is a Retrospective Challenge
If the SEC gives crypto security the opportunity to redress the unlawful acts or omissions, they have a retrospective challenge. The crypto security company has already raised money. It has a list of investors and amounts invested. Normally, companies choose an optimal financing method that aligns with corporate goals. Directors will balance factors such as cost, time delays, timing of a capital raise, existing investors, availability of new investors, desirability of regulator scrutiny etc. From that information, they opt for a financing option that is in the best interests of stakeholders. The reverse is true here: the crypto security company must find lawful financing method(s) to fit an already constituted investor base. A prospectus filed in all relevant jurisdictions may serve to cover most investors (subject to KYC and suitability); exemptions may not. It may be a complicated exercise to ensure all sales to all investors are lawful. And that assumes investors are prepared tie up their money and wait for the company to become all things compliant.
Jurisprudentially, the law must be consistent: “like cases must be treated alike.” Regulators and ultimately law-makers must enact logically defensible rules that are known, promulgated, and fair. We are in early stage clean-up. Crypto security players who persevere in the willful self-deception that they will avoid regulator scrutiny are unwise. The law may take time to evolve; the regulators may take time to enforce the law; but both are inexorable.
Future article: possible ways out of the mess: prospectus; exemptions; investment dealer; exempt dealer; exchange (marketplace); Alternate Trading Systems etc.
Richard Storey is a British Columbia based lawyer who specializes in securities and related structures. He has an MBA and a law degree from Cambridge University. For 12 years he worked in the world of financial derivatives (futures, forwards, options, swaps etc.) managing risk for large Canadian and U.S. companies.