United States: Cryptocurrencies And Digital Tokens As Securities

Since the release of Bitcoin in 2009, cryptocurrencies and digital tokens powered by blockchain technology have garnered the attention of investors, financial intermediaries and government agencies. Sales of digital tokens representing cryptocurrencies or some other digital asset or utility in so-called initial coin offerings (ICOs) have provided over $10 billion in capital to technology startups, and the aggregate market value of digital coins has surpassed $325 billion. ICOs have been typically open to the public through website platforms that link to white papers describing a startup's technological proposition. More often than not, ICOs fund little more than concepts and ideas rather than development stage businesses. Staying largely under the radar of financial regulators, many ICOs have been a source of fraud, market manipulation and the financing of illegitimate ventures.

The investigative report of the Securities and Exchange Commission (SEC) on The DAO in July 2017 served as a point of departure for the ICO marketplace. Over a 30-day period in mid-2016, The DAO, a digital decentralized autonomous organization initiated on the Ethereum blockchain, issued digital tokens worth $150 million to fund various "projects" that would be voted on by token holders. Investors in the tokens would share in the earnings from these projects and could sell DAO tokens on the open market over cryptocurrency exchanges. The SEC found that The DAO tokens were in fact securities under longstanding securities law principles and that any offer or sale of the tokens was subject to registration with the SEC unless there was a valid exemption. The SEC applied the Howey test, which dates back to 1946, in its analysis. Under the Howey test, a digital token is a security if it represents an investment of money in a common enterprise with a reasonable expectation of profits to be derived from the entrepreneurial or managerial efforts of others. The SEC concluded The DAO token squarely met the criteria under the Howey test, and found that the tokens were securities sold without registration or a valid exemption. The SEC also indicated that the platforms that traded The DAO tokens were required to register under a national securities exchange or operate under an exemption.

From the time The DAO report was issued, the SEC has stepped up oversight of the ICO market. Not all promoters of cryptocurrencies and digital tokens have accepted the securities label, and it remains to be seen if there will be judicial or legislative responses. The SEC's Chairman, in public remarks, has been clear that to date there has not been a digital token sold in an ICO that did not meet the definition of a security. He has stated, however, that there is consensus that Bitcoin is a not security.

As a twist on ICOs, many blockchain developers have offered and sold SAFTs instead of digital coins to raise capital. SAFT is the acronym for "Simple Agreement for Future Token Sales." SAFTs are essentially instruments for "pre-token" sales that provide funds for development of a proposed project. Once the project is functional, "utility" tokens are delivered to investors. The SAFTs are treated as a security but the utility tokens are not, on the theory that when the project is functional the utility token's value is determined by market or other factors and not the "managerial efforts of others" under the Howey test. The utility token can then be resold publicly without the restrictions that apply to securities. The SEC has not passed on the SAFT structure and there are no assurances the SEC will agree with the analysis.

To assist those who may be evaluating an ICO or similar offering involving digital tokens, set forth below is a chronology of SEC public statements, investor alerts and enforcement actions addressing securities law aspects of the ICO marketplace.

Public Statements

December 11, 2017 Statement on Cryptocurrencies and Initial Coin Offerings by SEC Chairman
SEC Chairman Clayton outlines his concerns about cryptocurrencies and the ICO market and the opportunities for fraud and manipulation. He notes that no ICO has ever been registered with the SEC, and urges market professionals, including securities lawyers, accountants and consultants, to follow longstanding registration, offering and disclosure requirements. Chairman Clayton highlights issues regarding digital asset trading platforms being unregistered securities exchanges and the obligation of broker dealers to comply with anti-money laundering and know your customer rules.

January 22, 2018 Opening Remarks at the Securities Regulation Institute
Chairman Clayton cautions lawyers, accountants, underwriters and dealers to be mindful of the securities laws when advising clients on ICOs.

January 24, 2018 Wall Street Journal Op-Ed: Regulators are Looking at Cryptocurrencies.
Joint Statement from SEC Chairman Clayton and CFTC Chairman Giancarlo explaining the SEC's and CFTC's role in bringing transparency and integrity to the ICO and bitcoin futures markets.

February 6, 2018 Chairman's Testimony on Virtual Currencies: The Roles of the SEC and CFTC
Chairman Clayton addresses the Senate Committee on Banking, Housing and Urban Affairs regarding steps the SEC has taken with respect to cryptocurrencies, ICOs and related assets.

February 7, 2018 SEC Office of Compliance Inspections and Examinations Announces 2018 Exam Priorities
OCIE announces it will include developments in cryptocurrency and ICOs among its examination priorities for SEC regulated entities such as broker-dealers and investment advisers.

March 7, 2018 Statement on Potentially Unlawful Online Platforms for Trading Digital Assets
SEC announces that platforms enabling trading of digital assets that are securities and operating as an "exchange" must register with the SEC as a national securities exchange or be exempt from registration.

April 26, 2018 SEC Chairman Testifies Before Congress
Chairman Clayton testifies before the House Committee on Appropriations, telling the Committee that tokens sold in ICOs are securities and should be regulated as such.

Investor Alerts

July 25, 2017 Investor Bulletin: Initial Coin Offerings
SEC issues an investor bulletin alerting promoters and investors that ICOs that can be securities and speculative investments subject to theft and fraud.

August 28, 2017 Investor Alert: Public Companies Making ICO-Related Claims
SEC issues warning to investors about potential scams involving stock of public companies making claims relating to ICOs, including pump-and-dump schemes, skimming and market manipulation.

November 1, 2017 SEC Statement Urging Caution Around Celebrity Backed ICOs
SEC alerts investors that celebrities have been endorsing potentially unlawful sales of ICOs without appropriate disclosure of the nature, scope and amount of compensation paid.

Enforcement Actions

April 11, 2017 Sunshine Capital
SEC suspends trading of Sunshine Capital stock on OTC Link based on accuracy of press releases concerning the liquidity and value of the company's cryptocurrency, DIBCOINS.

August 3, 2017 Strategic Global Investments
SEC suspends trading of Strategic Global Investments stock on OTC Link based on accuracy of press releases regarding activities of the company with respect to ICOs.

August 9, 2017 CIAO Group
SEC suspends trading of CIAO stock on OTC Link based on accuracy of press releases regarding, among other things, activities of the company with a planned ICO offering.

August 23, 2017 First Bitcoin Capital
SEC suspends trading of First Bitcoin securities due to the accuracy and adequacy of information about the company and its assets and capital structure.

September 29, 2017 REcoin
SEC charges a businessman and two companies with defrauding investors in a pair of unregistered ICOs that were purportedly backed by real estate and diamond investments.

December 4, 2017 PlexCorps
SEC obtained an asset freeze to halt an unregistered and fraudulent public ICO by PlexCorps, which promised an outsized return in a month's time.

December 11, 2017 Munchee
A company selling digital tokens to raise capital for its food review service halted its ICO after the SEC contacted the company. The company agreed to an SEC order finding that the company engaged in the offer and sale of unregistered securities.

January 30, 2018 AriseBank
The SEC obtains a court order stopping an unregistered ICO by AriseBank, promoted as the first "decentralized bank" that would offer banking products and services for consumers using more than 700 cryptocurrencies. AriseBank claimed it purchased an FDIC-insured bank so it could maintain FDIC insured accounts and also offer a VISA for spending any of the cryptocurrencies.

February 16, 2018 Cherubim Interest, PDX Partners and Victura Construction Group
SEC suspended trading in three companies for misleading statements about the acquisition of cryptocurrencies and blockchain technology assets.

February 21, 2018 BitFunder
SEC charges bitcoin exchange and its operator with operating an unregistered securities exchange and defrauding users of the exchange by failing to disclose a cyberattack resulting in theft of bitcoins.

February 28, 2018 Cryptocurrency Firms Targeted in SEC Probe
Wall Street Journal reports that the SEC has issued dozens of subpoenas and information requests to technology companies and advisers involved in the cryptocurrency market.

April 2, 2018 Centra Tech
SEC charges founders of financial service start-up with conducting a $32 million unregistered, fraudulent ICO. The founders promoted the ICO by touting nonexistent relationships with Visa, MasterCard and The Bancorp.

April 6, 2018 Longfin
SEC obtains a court order freezing $27 million in trading profits from illegal distributions and sales of Longfin stock after the company publicly announced the acquisition of a purported cryptocurrency business. Longfin had previously completed a series of offerings under Regulation A, but failed to disclose the acquisition.

April 11, 2018 Long Blockchain
Company that operates a beverage distribution business changed its name from Long Island Iced Tea Corp to Long Blockchain. Its shares rose 183% after the announcement, then fell dramatically as the price of bitcoin plunged. The company's subsequent market capitalization fell below the Nasdaq listing requirements and trading in the stock was halted.

Disclaimer: This Alert has been prepared and published for informational purposes only and is not offered, nor should be construed, as legal advice. For more information, please see the firm's full disclaimer.

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