In the past few years, and particularly in the past few months, cryptocurrencies or digital currencies – most notably bitcoin and ether – have surged in popularity and dominated the financial press and to some degree even the mainstream media. The value of the most famous cryptocurrency, bitcoin, has reached historically high levels.
Given the increasing demand for cryptocurrencies, it is no surprise that market participants are responding and racing to satisfy that demand by producing more such currencies or so-called tokens representing the currencies. Additional currencies, or to be precise the tokens representing interests in such currencies, are produced and disseminated by a process colloquially known as an “initial coin offering” or “ICO,” not coincidentally a term which is similar to the better-known term “IPO.” As with all new technologies, regulators have been slow to catch up, but they now appear to have done so.
Depending on the characteristics of the cryptocurrency, the token and the method by which it is created and disseminated, a number of state and federal regulators might assert jurisdiction, but significantly the Securities and Exchange Commission, among others, has taken note of these developments and begun to act. Central to the threshold question of whether the SEC has jurisdiction to regulate these activities is the question of whether, as the agency’s very name implies, the token in question is a “security” and, in turn, whether the offer, sale and/or other distribution of such a token (such as via an ICO) would be deemed an offering of a security.
The SEC has concluded that in many instances a cryptocurrency token in fact would meet the legal definition of a security and thus be subject to its jurisdiction, and therefore the offer or sale of such a security also must comply with the federal securities laws. In its first significant statement on the topic last July, the SEC set forth the basic circumstances under which a cryptocurrency token, such as one issued through an ICO, would be deemed a security and subject to regulation as such. Despite the novel technologies and other techniques employed in the cryptocurrency industry, the SEC’s legal analysis relies on a traditional analysis of the definition of a security under the “investment contract” test and whether the tokens in question met that definition. The SEC reaffirmed the fundamental principle under this test that the “hallmark of a security is an investment of money or value in a business or operation where the investor has a reasonable expectation of profits based on the efforts of others” and noted that anyone who solicits something of value in exchange for an interest in a digital or other novel form of storing value, such as a cryptocurrency, should carefully consider whether they are creating an investment arrangement that constitutes a security. The SEC further explained that not only must any offer and sale of such a security comply with the fundamental registration and disclosure requirements under the Securities Act of 1933, but market participants must also consider other aspects of the federal securities laws if they conclude that the assets in question meet the definition of a security. According to the SEC, additional potential obligations include the following:
- If a platform facilitating transactions in such securities is operating as an “exchange,” the platform may require registration as an exchange or “alternative trading system” under the Securities Exchange Act of 1934.
- If a person facilitates the purchase and sales of the token, in either the primary or secondary markets, the person may need to register as a broker-dealer under the Securities Exchange Act of 1934.
- If the composition of assets of the entity offering and selling the security causes it to meet the definition of an “investment company,” even if inadvertently or temporarily, the entity may require registration under the Investment Company Act of 1940.
- If a person provides advice about an investment in the security, that person may be deemed an “investment adviser” and may need to register as such under the Investment Advisers Act of 1940.
While the DOA Report was perhaps the most notable SEC statement in this area, the SEC has been increasingly active and has issued a number of investor alerts, bulletins and statements on ICOs and cryptocurrency-related investments, all of which contain valuable legal and practical guidance. Faced with an almost frenzied growth of the industry, the SEC chairman, Jay Clayton, himself issued perhaps the most prominent and comprehensive statement in this area on Dec. 11. While this and other SEC statements certainly highlight the relevant risks and regulatory obligations in the area, it is important to note that, at the same time, the SEC is not attempting to shut down the industry, assuming the relevant rules are followed. Chairman Clayton concludes his Dec. 11 statement as follows: “The technology on which cryptocurrencies and ICOs are based may prove to be disruptive, transformative and efficiency-enhancing. I am confident that developments in fintech will help facilitate capital formation and provide promising investment opportunities for institutional and Main Street investors alike. I encourage Main Street investors to be open to these opportunities, but to ask good questions, demand clear answers and apply good common sense when doing so. When advising clients, designing products and engaging in transactions, market participants and their advisers should thoughtfully consider our laws, regulations and guidance, as well as our principles-based securities law framework, which has served us well in the face of new developments for more than 80 years.”
While statements from the SEC such as this one open the door for the industry to develop in a lawful and properly regulated manner, apart from providing useful regulatory guidance, the SEC has also demonstrated that it will act where necessary to halt and punish unregistered or fraudulent ICOs and other such unlawful cryptocurrency transactions. Not surprisingly in recent months – and even days – the SEC has begun to bring a series of enforcement actions to stop fraudulent, unregistered or otherwise unlawful schemes.
While fintech generally, and cryptocurrencies in particular, present great opportunities – both as new and valuable technologies as well as potentially lucrative investment vehicles – it is now apparent that regulators such as the SEC have taken notice. While it seems there is no intention of shutting down the industry, regulators – and particularly the SEC in instances where cryptocurrency transactions, notwithstanding the terminology or jargon employed, are essentially transactions in securities – have made it clear that the industry cannot operate above the law. For its part, the SEC has given notice that it intends for cryptocurrency transactions involving securities and the securities markets to comply with the pertinent securities laws and to ensure that investors and market participants are afforded the protections of such laws.
Report of Investigation Pursuant to Section 21(a) of the Securities Exchange Act of 1934: The DAO (July 25, 2017), available at https://www.sec.gov/litigation/investreport/34-81207.pdf (the “DAO Report”).
Statement on Potentially Unlawful Promotion of Initial Coin Offerings and Other Investments by Celebrities and Others (Nov. 1, 2017), available at https://www.sec.gov/news/public-statement/statement-potentially-unlawful-promotion-icos; Investor Alert: Public Companies Making ICO-Related Claims (Aug. 28, 2017), available at https://www.sec.gov/oiea/investor-alerts-and-bulletins/ia_icorelatedclaims; Investor Bulletin: Initial Coin Offerings (July 25, 2017), available at https://www.sec.gov/oiea/investor-alerts-and-bulletins/ib_coinofferings; Investor Alert: Bitcoin and Other Virtual Currency-Related Investments (May 7, 2014), available at https://www.investor.gov/additional-resources/news-alerts/alerts-bulletins/investor-alert-bitcoin-other-virtual-currency; Investor Alert: Ponzi Schemes Using Virtual Currencies (July 23, 2013), available at https://www.sec.gov/investor/alerts/ia_virtualcurrencies.pdf.
Statement on Cryptocurrencies and Initial Coin Offerings (Dec. 11, 2017), available at https://www.sec.gov/news/public-statement/statement-clayton-2017-12-11.
Press Release, Company Halts ICO After SEC Raises Registration Concerns (Dec. 11, 2017), available at https://www.sec.gov/news/press-release/2017-227; Press Release, SEC Emergency Action Halts ICO Scam (Dec. 4, 2017), available at https://www.sec.gov/news/press-release/2017-219; Press Release, SEC Exposes Two Initial Coin Offerings Purportedly Backed by Real Estate and Diamonds (Sept. 29, 2017), available at https://www.sec.gov/news/press-release/2017-185-0.