Guest post by– Cleary Gottlieb Steen & Hamilton LLP
On November 16, 2018, the U.S. Securities and Exchange Commission (“SEC”) Division of Corporation Finance (“Corp. Fin.”), Division of Investment Management, and Division of Trading and Markets issued a joint public statement on “Digital Asset Securities Issuance and Trading.” The public statement is the latest in the Divisions’—and the Commission’s—steady efforts to publicly outline and develop its analysis on the application of the federal securities laws to initial coin offerings (“ICOs”) and certain digital tokens. These efforts have combined a series of enforcement proceedings with public statements by Chairman Jay Clayton and staff, including a more detailed statement of the SEC’s analytical approach in Corp. Fin. Director William Hinman’s speech on digital assets in June 2018.
The Divisions’ statement reflects on the Commission’s efforts to balance “encourag[ing] technological innovations that benefit investors” in the financial technologies space with ensuring that market participants adhere to the “federal securities law framework when dealing with technological innovations.” To this end, the Commission’s enforcement actions and public guidance have largely revolved around three issues: (1) ICOs and the sale of digital assets; (2) “investment vehicles investing in digital asset securities and those who advise others about investing in these securities;” and (3) the secondary market for digital assets.
The statement notes that, with respect to the first category, the Commission’s actions have focused on the questions of when a digital asset is a “security” under securities laws, and what requirements apply when it is. The Commission’s guidance on these questions first came in the form of the 2017 DAO Report, which found that the digital assets at issue were securities and therefore subject to registration, anti-fraud, and other requirements under the federal securities laws, followed by a string of enforcement actions finding that particular digital assets are securities.
With respect to the second category of cases—investment vehicles investing in digital assets—the statement emphasizes that the regulatory framework established by the Investment Company Act “applies to a pooled investment vehicle, and its service providers, even when the securities in which it invests are digital asset securities.” Citing to a September 2018 order against a manager of a hedge fund formed to invest in digital assets, the statement cautions managers of investment vehicles holding digital assets to be mindful of “registration, regulatory and fiduciary obligations” under both that Act and the Investment Advisers Act.
Finally, in cases involving secondary market trading of digital assets, the Commission has “focused on what activities require registration as a national securities exchange or registration as a broker or dealer.” Here, the statement cautioned that entities will be assessed based on “[t]he activity that actually occurs between the buyers and sellers,” rather than “the kind of technology or the terminology used by the entity” or “how an entity may characterize itself.” For example, the statement notes that systems that display trading interests to users or receive users’ orders centrally for future processing and execution may “bring together orders of multiple buyers and sellers” under Rule 3b-16(a). Likewise, the statement notes that entities that provide an algorithm—whether run on a program or a smart contract using blockchain technology—to bring together or execute orders could be providing a trading facility. Entities that set execution priorities, standardize material terms for traded digital assets, or require orders to conform with smart contract protocols may be setting rules. This was the case in the Commission’s recent settlement for failing to register as an exchange with the founder of EtherDelta, an online platform that provided secondary market trading of digital tokens through the use of an order book, a website that displayed orders, and pre-programmed trading protocols defined in the EtherDelta smart contract.
The Divisions’ statement is the latest example of the Commission’s recent model of providing guidance to market participants through public notice, followed shortly by enforcement actions. Since the DAO Report, the Commission has issued public statements and enforcement actions addressing nearly the full range of entities engaged in the digital assets and ICO space.
For example, over the last year, the Commission brought its first enforcement action against an unregistered broker-dealer selling digital tokens and against a hedge fund manager engaged in an unregistered non-exempt public offering related to digital asset investments. Then, just last week, the Commission brought its first action against EtherDelta, a decentralized digital asset trading platform. Finally, on the same day that the Divisions’ public statement was issued, the Commission announced a settlement with two ICO issuers—Airfox and Paragon—the first such case imposing civil penalties solely for ICO offerings registration violations.
The Airfox and Paragon settlements are also notable because they “demonstrate that there is a path to compliance with the federal securities laws” for companies that have conducted unregistered ICO offerings. In both cases, the Commission imposed a flat $250,000 civil penalty and requirements to register their tokens with the Commission within 90 days and compensate harmed investors. As the statement explains, the registration undertakings are designed to ensure that investors receive the type of information that they would have had the issuers properly registered in the first instance and permit them to seek reimbursement or continue to hold the tokens. While this solution may obviate concerns among ICO issuers that rescission is itself an offer subject to registration requirements, the Commission’s statements nonetheless generate uncertainty about whether similar avenues to compliance will be permitted in the future. The press release accompanying the orders characterize the orders as “a model for companies that have issued tokens in ICOs” and seek to comply with the law, while simultaneously warning that the cases “tell those who are considering taking similar actions that [the Commission] continue[s] to be on the lookout for violations of the federal securities laws.”
Despite the Divisions’ public statement and the fact that the Commission’s enforcement actions on digital assets and ICOs have now largely spanned the array of market participants, several key questions about the Commission’s view on cryptocurrencies and ICOs remain unsettled. For example, the Divisions’ statement and the Commission’s settlements do little to clarify outstanding questions about when and how the federal securities laws apply to digital assets outside of the circumstances seen in recent actions. The determination of both digital assets as securities and decentralized digital asset trading systems as exchanges will continue to depend on a “functional approach” that takes “into account the relevant facts and circumstances” at issue. Although Corp. Fin. Director Hinman has indicated that the Commission will in the near future release “Plain English” guidance regarding these issues to token issuers and market participants, going forward, the Commission’s guidance will nonetheless likely come in the form of piecemeal guidance through regular enforcement actions rather than warnings or formal rulemaking.