Digital assets, popularly referred to as
"cryptocurrencies", "coins", and
"tokens", continue to provoke regulatory attention and
create discord amongst regulators. Recent actions by the U.S.
Commodity Futures Trading Commission ("CFTC") and the
U.S. Securities and Exchange Commission ("SEC")
demonstrate that activities by the issuers of tokens may draw
scrutiny from either or both agencies. As new token issuance
schemes hit the market every day, cryptocurrency market
participants must be cautious because multiple regulatory
enforcement arms are becoming increasingly active in this rapidly
evolving arena.
On September 27, we discussed the latest CFTC enforcement action
involving cryptocurrencies in a
client alert available here. In that case, the CFTC brought an
enforcement action against a group of defendants for fraudulently
soliciting investments for a pooled fund that traded the digital
asset bitcoin. Interestingly, the pooled fund did not trade
derivative instruments (e.g., futures, options, swaps). The CFTC
nevertheless asserted its general jurisdiction over commodities
under the Commodity Exchange Act. The CFTC's view is that any
digital asset-related transaction or solicitation that involves
fraud or manipulation is within the CFTC's territory.
We also have previously alerted readers to the prior SEC
enforcement activities in connection with initial coin offerings
ICOs, including the SEC's pronouncement with respect to The DAO
ICO (client alert available here), and the SEC's suspension of
trading of three already public companies in connection with the
adequacy of their disclosures concerning their ICOs (
client alert available here).
On September 29, 2017, in a first-of-its-kind action, the SEC
charged a businessman and two companies with defrauding investors
in a pair of ICOs. In its press release, the SEC alleges that
Maksim Zaslavskiy ("Zaslavskiy") and his companies,
ReCoin Group Foundation ("ReCoin") and DRC World (also
known as Diamond Reserve Club) ("DRC," and together with
ReCoin, collectively, the "Companies"), sold unregulated
securities in the form of cryptocurrencies, purportedly backed by
assets that did not exist. According to the SEC's complaint,
investors in the Companies were told they could expect sizeable
returns from the Companies' operations, when the Companies had
no real operations. As we have previously noted, an ICO that is
premised on an increase in value of the token as a consequence of
the profits of the issuers' business operations, more closely
resembles the issuance of a security than an ICO in which the token
is redeemable for goods or services.
ReCoin was publicized as "The First Ever Cryptocurrency
Backed by Real Estate." Investors were told by Zaslavskiy that
ReCoin had a "team of lawyers, professionals, brokers, and
accountants" who would make real estate investments with the
ICO proceeds. However, the SEC claims no personnel were hired or
consulted to invest the raised funds. Additionally, the SEC has
alleged that Zaslavskiy and ReCoin misrepresented that they had
raised between $2 million and $4 million from investors, when only
$300,000 had been raised.
Similarly, DRC was advertised as a cryptocurrency backed by
investments in diamonds, and claimed that individuals could
purchase "memberships" in the company to obtain discounts
with product retailers. The SEC alleges that Zaslavskiy and DRC had
not purchased any diamonds and had not engaged in any business
operations.
Through an emergency court order by a federal district court in
Brooklyn, New York, the SEC froze the assets of Zaslavskiy and of
the Companies on the basis of violations of the anti-fraud and
registration provisions of the federal securities laws. The SEC is
pursuing permanent injunctions, disgorgement, interest, and
penalties against the Companies and Zaslavskiy. Additionally, the
SEC is seeking to bar Zaslavskiy from participating in any
offerings of digital securities ("Security Tokens") in
the future.
The SEC's actions follow its investor alert warning about
the risks associated with ICOs, and its recent press release
outlining the creation of a Cyber Unit and Retail Strategy Task
Force, focused on policing cyber-based threats and protecting
retail investors. The SEC's creation of these new units was
discussed in a previous Reed Smith client post available
here.
Multiple Potential Regulators
The CFTC and SEC both have jurisdictional authority to pursue
fraud and manipulation cases involving digital asses. This is not a
unique situation. There have been other cases where multiple
regulators brought enforcement actions concerning the same
activity. Market participants should be cognizant of the risk that
both agencies might bring enforcement actions against them that
result in separate civil monetary penalties, as occurred in the BP
and Hunter market manipulation cases involving both the CFTC and
FERC.1
Neither the CFTC nor the SEC has exclusive jurisdiction over
these products and markets. In the Hunter case, for
example, the Court of Appeals for the D.C. Circuit cited the
CFTC's exclusive jurisdiction over futures to delineate between
cases involving natural gas trading, which are within FERC's
jurisdiction generally, and cases involving natural gas
futures trading, which fall within the CFTC's
exclusive jurisdiction over futures. Without such a distinction, it
is possible for both, and even other regulators (e.g., the
Department of Justice), to bring a case to court based upon the
same endeavor.
The issuers of the tokens in the Zaslavskiy case are alleged to
have fraudulently represented that their tokens were backed by
assets. The SEC claims the underlying assets in Zaslavskiy had not
been acquired or set aside by the promoters – the assets
simply did not exist. One of the significant questions raised by
the SEC's recent actions is whether the SEC will recognize the
distinction between a "Utility Token" and a
"Security Token," and how a true asset-backed token
(e.g., oil or precious metals held in storage) will be
regulated.
Conclusions
The CFTC and SEC have made clear that they will increasingly
scrutinize ICOs and token issuances, and will devote more resources
to enforcement actions. Accordingly, it is more important than ever
that anyone contemplating an ICO understand how to comply and
safely sponsor an ICO.
While there has been no guidance on how whitepapers should be
structured to be compliant with federal securities laws, issuers
may look to traditional Form S-1s or Reg. D private placement
structures for guidance on creating a whitepaper for Security
Tokens. Unfortunately, no clear regulatory currently exists for
offerings of utility tokens, and utility token issuers must
therefore be well advised as to the applicability of SEC and CFTC
regulations to their ICOs. It is also abundantly clear that CFTC
and SEC anti-fraud and anti-market manipulation regulations likely
will apply.
While this alert focuses only on the most recent SEC and CFTC
actions, any issuer must also be mindful of compliance issues
arising under state laws, under other federal laws (e.g., banking
and payments regulations), and under the laws of any country where
a token might be issued or traded. Compliance with one set of laws
and regulations does not guarantee compliance with the laws and
regulations of any other state or country.
Footnote
1 Hunter v. F.E.R.C., 711 F.3d 155, 157 (D.C. Cir.
2013).
This article is presented for informational purposes only
and is not intended to constitute legal advice.
