What Lessons Can Token Issuers Learn from Recent Federal / State Securities Enforcement Activity?

In this article we discuss a number of lessons that we believe issuers of digital tokens can draw from recent enforcement actions brought by federal and state securities regulators. But we first need to define the perimeter we will be covering.

There has been a veritable explosion of U.S. regulatory activity in the blockchain-based digital assets space over the past two months. We are going to focus on enforcement actions brought by U.S. state and federal securities regulators.  In a subsequent article, we plan to analyze developments in commodities and derivatives regulation and the recent activities of the CFTC.

[clickToTweet tweet=”There has been a veritable explosion of U.S. regulatory activity in the #blockchain-based digital assets space over the past two months #ICO” quote=”There has been a veritable explosion of U.S. regulatory activity in the #blockchain-based digital assets space over the past two months #ICO”]

Also, we won’t discuss the remarks that CoinDesk reports that SEC Chairman Jay Clayton recently made at Princeton University, where he largely reaffirmed existing positions. While he did state that a token can evolve from a security into a non-security, which is novel, he did not elaborate regarding the circumstances under which this might occur, leaving market participants without any guidance on how to achieve this.

Finally, because we are focused primarily on issuers of tokens, we will not discuss the New York Attorney General’s (NYAG’s) recently announced Virtual Markets Integrity Initiative, which the NYAG inaugurated by sending questionnaires concerning trading policies and procedures to 13 cryptocurrency exchanges.  We restrict our scope to issuers in order to avoid losing focus – exchanges and other financial intermediaries are a whole different ballgame, so to speak.

Having defined our perimeter, we now dive into our analysis!

The Securities and Exchange Commission

The SEC has been quite active in the blockchain-based digital assets space over the past two  months.  The Wall Street Journal reported in late February that the SEC had quietly sent a wave of subpoenas to market participants in the Initial Coin Offering (ICO) space.  There have been numerous discussions between the SEC and ICO issuers behind the scenes or in private, but since such correspondence is by nature non-public, we can’t analyze it here.  Publicly, much of the SEC’s attention has been focused on intermediaries, such as exchanges.  In late February, the SEC brought a case against an unregistered securities exchange (Bitfunder ) and its operator, Jon E. Montroll, alleging fraud and registration violations.

In early March, the SEC released a Public Statement warning online token trading platforms that they may be unregistered securities exchanges.

With respect to token issuers, however, the SEC’s publicly-disclosed activities have been less numerous. On April 2, 2018 it charged the principals of a token issuer called Centra Coin that had conducted an ICO with fraud and registration violations.

This is a relatively straightforward fraud case involving a number of alleged misrepresentations – Centra claimed to have created a cryptocurrency debit card that, because of partnerships with Visa and Mastercard, could be used anywhere throughout those card companies’ vast worldwide merchant networks.

However, the SEC alleges this was a wholesale fabrication – no debit card had been developed, and no such partnerships with major card network ever existed. The SEC also alleges the promoters created fictional personas of key management figures – creating fake LinkedIn profiles featuring prestigious (made up) credentials for a “Michael Edwards”, Centra’s alleged CEO and co-founder, and “Jessica Robinson”, the purported CFO.

The SEC alleged neither Edwards nor Robinson was a real person. Furthermore, the promoters claimed investors would be paid a 0.8% dividend based on the purported “revenue share” agreement with Visa and Mastercard – but this was just another lie, according to the SEC. Finally, the SEC charged that Centra’s ICO was an unregistered securities offering and so Centra violated §5 of the Securities Act of 1933.

As noted previously, this is largely a straightforward fraud case, so for non-fraudulent token issuers conducting ICOs, it doesn’t really add much to what is already known: (1) don’t lie, and (2) treat your ICO as a securities offering and either register it with the SEC or qualify for an exemption.

The SEC here conclusory stated, without giving any explanation or discussing the Howey factors, that “[t]he investments offered during the Centra ICO were ‟securitiesˮ within the meaning of… the Securities Act and… the Exchange Act.”

Conducting our own analysis, the 0.8% dividend that the promoters (fraudulently, according to the SEC) promised would be paid to Centra token holders out of the “revenue share” agreement with the card networks clearly resembles a feature associated with an “investment contract”, i.e. a security.

Also, the expectation of profits “from the efforts of others” prong of the Howey test appears easily satisfied – the ICO marketing materials urged potential token purchasers to “join our success and mission while generating a profit.” The individual defendants, Trapani, Sharma, and Farkas conducted the lion’s share of the ICO’s marketing themselves, by dreaming up the scheme as a whole, making up the Visa and Mastercard partnerships, and drafting promotional materials, creating and maintaining a social media presence,  fabricating the personas of Michael Edwards and Jessica Robinson, securing celebrity endorsements, etc.

Any profits accruing to buyers of tokens in the ICO from appreciation in the token’s value derived largely from Sharma’s and Farkas’ promotional and entrepreneurial efforts, and such token buyers were part of a common enterprise, both with respect to Sharma and Farkas as well as with respect to each other.  Given these circumstances, perhaps the SEC thought its position was strong enough that it was unnecessary to engage in a formal Howey analysis.

We next turn to two of the most assertive securities regulators at the state level, the Massachusetts Securities Division and the Texas State Securities Board, to see if there are any lessons for token issuers from their activities.

Massachusetts

Massachusetts’ securities regulator, the Securities Division of the Office of the Secretary of the Commonwealth (“Securities Division”), has been very persistent in terms of enforcing Massachusetts securities law in the virtual currency space.

Following in the SEC’s footsteps, in late March, 2018, the Securities Division decided to conduct its own “ICO Cryptocurrency Sweep” that resulted in a series of consent orders against the issuers of 5 ICOs.  None of the issuers had either registered with the Securities Division, or complied with a state-law registration exemption, which was the basis of the enforcement actions.

However, no charges of fraud were levied against the issuers. The outcome was that, in most cases, the ICOs terminated, with the issuers required to offer rescission rights to investors, as well as banned from conducting future securities offerings (including future ICOs or token offerings) in Massachusetts without first notifying the Securities Division.

One case – In the Matter of Sparkco, Inc. d/b/a Librium – is particularly notable, because it offers lessons on how a common market practice can result in liability.  In Sparkco the issuer tried to limit the sale of the tokens solely to persons outside the U.S., or to accredited investors within the U.S, in reliance on (federal) Regulation D and Regulation S respectively, without triggering registration requirements.

This is the route that many ICOs which attempt to comply with U.S. securities laws have taken. When you sell tokens to persons in the U.S. and meet the requirements of the federal Regulation D private offering exemption, state law registration requirements are preempted, meaning they do not apply.

However, to get the benefit of federal preemption, the issuer must actually and successfully comply with Regulation D – a mere attempt at qualifying for Regulation D that is unsuccessful is ineffective to preempt state law registration requirements, as many courts have held.

Furthermore, even if state registration requirements are preempted and inapplicable, states often impose additional requirements – commonly, to file a notice of the Regulation D offering with the state securities regulator, pay a fee, and consent to service of process in that state – that issuers must comply with. (Note: State securities laws are sometimes referred to as “blue sky laws”)

[clickToTweet tweet=”Massachusetts’ securities regulator, the Securities Division of the Office of the Secretary of the Commonwealth, has been very persistent in terms of enforcing Massachusetts securities law in the virtual currency space #ICO” quote=”Massachusetts’ securities regulator, the Securities Division of the Office of the Secretary of the Commonwealth, has been very persistent in terms of enforcing Massachusetts securities law in the virtual currency space #ICO”]

We don’t know the reason why Sparkco’s attempt to comply with Regulation D strategy was not successful, because the description of the facts in the Sparkco consent order is extremely sparse and the order itself offers no details. However, one possibility is that Sparkco’s proprietary compliance software did not work as intended, whether due to faulty design, technical failures that led it to not work properly, or some other reason, thereby allowing non-qualified U.S. investors to participate in the ICO. The Securities Division noted that:

“Sparkco had built an automated web-based tool for use during a sale of [the tokens] with the specific
ability to verify the purchaser of … tokens as fitting the specified qualifications of… an “Accredited
Investor” and or [sic] being a “Foreign Investor.””

Had Sparkco’s automated compliance software worked properly and ensured that every one of Sparkco’s sales to U.S. investors been made in compliance with Regulation D, it would not have been subject to Massachusetts registration requirements.  Another possibility is that Massachusetts investors were allowed to participate in the Regulation S-only (outside the U.S.) offering – which actually happened in a different Massachusetts case that we discuss below.

A technical glitch in automated compliance software is not the only possible explanation for why Sparkco failed to qualify for Regulation D.  For instance, another requirement imposed by Regulation D is that the issuer file a Form D with the SEC within 15 days after it first starts selling securities in an exempt offering.  Sparkco does not appear to have done so.

Without filing a Form D, Sparkco would not have conducted a valid Regulation D offering, and therefore would not be entitled to federal preemption of Massachusetts registration requirements.

Furthermore, even if an issuer conducts a valid Regulation D offering and therefore avoids state law registration requirements, many states – including Massachusetts – require issuers to meet certain additional requirements, such as to file a notice with the state securities regulator, pay a filing fee, and consent to service in their state, among others. Even assuming Sparkco conducted a valid federal Regulation D offering, Sparkco does not appear to have complied with these additional “blue sky” requirements under state law, which is another thing that could have exposed Sparkco to liability in Massachusetts.  Ultimately, given the imperfect factual development in the Sparkco Consent Order, we can only speculate.

As noted above, Sparkco is not the only case where the fallibility or inadequacy of compliance software (potentially) caused a violation of securities law.

An earlier Massachusetts Securities Division enforcement action, In the Matter of Caviar and Kirill Bensonoff,  also involved a compliance software failure.

In Caviar, an ICO issuer conducted an ICO that relied on excluding all U.S. investors to avoid the registration requirements of the U.S. securities laws.  The issuer hired a third party vendor to supply software that would screen out U.S. persons “based on criteria such as a prospective purchaser’s IP address” and the geolocation information derived from it.  Potential purchasers with U.S. IP addresses identified by the software were required to upload government-issued photo identification, which would be reviewed manually by the ICO issuer’s personnel and, if necessary, prohibited from participating in the ICO.

The Securities Division found that these safeguards were not enough, based on the fact that;

“Caviar’s identity verification procedures are relatively easy to circumvent, and inadequate to prevent the sale of Caviar tokens to Massachusetts investors.” 

As evidence of this, at least two U.S. investors, including a Massachusetts-based investigator employed by the Securities Division who gave the name of a “popular cartoon character” that did not match the photo ID that the investigator provided, were nevertheless approved following a personal review by Caviar.

The Sparkco and Caviar enforcement actions should serve as a reminder to ICO issuers who intend to rely on automated compliance software that they need to take exacting pains to ensure that the software works exactly as it is supposed to, and that it is not “relatively easy to circumvent” by ineligible investors.

Sparkco also raises the issue of needing to satisfy with all aspects of Regulation D – such as the requirement to file a Form D within 15 days of the first sale.  Failing to qualify for the federal Regulation D registration exemption has dire consequences, as it exposes the issuer to the need to follow the registration requirements in each state in which the securities are offered. Furthermore, even if an issuer does validly comply with Regulation D, most states still impose other “blue sky” requirements – e.g. notice filings, filing fee, and consent to service of process in the state – which, although less substantive, must nevertheless be complied with.

Texas

Like Massachusetts, Texas’ State Securities Board (the “TSSB”) has also launched a crackdown of its own against blockchain-based digital asset issuers. On April 10 it released a report (the “TSSB Report”) describing the findings of a four-week investigation it conducted, starting in December 2017, into “securities offerings tied to virtual currencies.”

We think the TSSB has been remarkably active in the virtual currency realm.  During the investigation itself, it opened 32 investigations into promoters of virtual currencies, contributing to the TSSB’s cumulative total of about 60 investigations since September 2017, out of which seven enforcement actions have developed.  The natural question that emerges, though, is why did only some TSSB investigations turn into enforcement actions, while others avoided that outcome?  What factors or conduct does the TSSB view as meriting the conversion of an investigative file into an enforcement action?

In answering this question, the best place to start is the issue of jurisdiction.  In this connection, the TSSB stressed that “[i]t is important to note” the following distinction:

[T]he TSSB is not regulating the cryptocurrencies themselves, only the investments that claim to use virtual currencies in an investment program. [Emphasis added.]

The TSSB therefore appears to draw a distinction between decentralized cryptocurrencies like Bitcoin, which would typically be outside its jurisdiction, on the one hand, and, on the other, cases where decentralized virtual currencies like Bitcoin are used as part of an investment program, in which case such investment programs would be within the TSSB’s jurisdiction.

What does the TSSB think an investment program – a security – based on an otherwise non-jurisdictional commodity (e.g. Bitcoin), looks like?

The answer seems to be that the promoter is offering a return generated primarily by its own efforts – whether by mining, lending, trading, or guaranteeing investors a profitable return.  It stands to reason that the TSSB would likely not consider pure Bitcoin spot transfers, conducted on a principal to principal basis (as opposed to trading conducted through an investment manager or financial intermediary), as being within its jurisdiction.

In the USI Tech case, the promoters promised to pay investors a 1% daily return using value generated by the venture’s “interest in a series of Bitcoin mining contracts.”

[clickToTweet tweet=”Like Massachusetts, Texas’ State Securities Board has also launched a crackdown of its own against #blockchain-based digital asset issuers #ICO” quote=”Like Massachusetts, Texas’ State Securities Board has also launched a crackdown of its own against #blockchain-based digital asset issuers #ICO”]

In the LeadInvest case, the promoters offered three cryptocurrency-related investments – a cryptocurrency trading program where profits would be derived from trading gains; a Bitcoin mining program whose profits would arise from mining new Bitcoin; and a fiat lending program, where investors would lend fiat, which the promoters would onward lend to borrowers as fiat or after converting to Bitcoin, in exchange for periodic payments of interest and principal.

In the Financial Freedom Club / 911MoneyStore case, investors would invest fiat, their funds would be pooled, and then the pool operator would purchase cryptocurrency investments and pay investors from the proceeds generated therefrom.

In the Davorcoin and Bitconnect cases, the instruments themselves purported to be decentralized virtual currencies, but the issuers offered “lending programs” whereby the investors would use Bitcoin to purchase Davorcoin or BitConnect Coins, and then would purportedly lend their newly-acquired Davorcoin or BitConnect Coins back to the issuers in exchange for a specified interest rate (in BitConnect’s case, up to 40% per month, plus additional daily interest).

Apart from the role of the promoter or issuer in generating profits, other factors which seemed to draw the TSSB’s attention include, for example (the following is not an exhaustive list):

  • Unregistered Sales Agents/Referrals. Out of the 32 cryptocurrency schemes the TSSB investigated during the period covered by the TSSB Report, six of them actively recruited members of the public to become unlicensed sales agents, or paid them for referrals, without requiring them to first pass a competency exam or undergo a background check, as licensed securities professionals typically are required to in Texas. Yet, of the TSSB’s total of seven enforcement actions, no less than five (USI Tech, R2B Coin, LeadInvest, BitConnect, and DavorCoin) targeted investment programs that used these practices.
  • Outrageous Profitability Claims. Claims of “outrageous” profitability were commonplace, whether in connection with the cryptocurrency being marketed (e.g. BitConnect’s 40% monthly profit claim), or based on an analogy to an unrelated cryptocurrency such as Bitcoin. As an example  of the first tactic, the promoters of R2B Coin claimed that “r2b coin [sic], if you study the history, only goes one way, and that’s up… [w]e’re only going up… [w]e never go down in value.” In terms of the second tactic, that of drawing analogies with an unrelated cryptocurrency, the TSSB noted that “[m]any solicitations played on bitcoin’s sharp increase in price, even though the investment being marketed to investors had nothing to do with bitcoin”, for the purpose of making investors fearful of missing out on the present opportunity. The TSSB stated that such a marketing tactic is misleading because it ignores the inherent risks of investing in virtual currencies, such as pricing volatility, hacks or theft, or the impact of tighter regulation.
  • No Address. Out of 32 investigations, the TSSB found that only 11 promoters provided investors with their physical address, with the other 21 only existing solely in cyberspace, leaving investors with no way to locate a promoter to serve legal process on in case of fraud.
  • Lying about Management Team. In the most egregious example, the promoter in LeadInvest passed off photos of random, entirely-unaffiliated persons as members of their (fictional) management team. For instance, the “CodeOfEthics [sic] Association” of LeadInvest was accompanied by a photo of U.S. Supreme Court Justice Ruth Bader Ginsburg together with a number of former U.S. Solicitors General, none of whom were actually associated with LeadInvest in any capacity. Although these actions are as ridiculous as they are reprehensible, they do serve as a reminder to entities engaging in token offerings that they need to accurately depict the biographies and prior experience of their management teams. For instance, it is common practice in the ICO industry to list prominent persons as “advisors”, while remaining vague about the details of their actual involvement.  To avoid misleading investors, if such advisors are not expected to devote their full time to the company’s affairs, have substantial outside time commitments, or have positions with competing companies which could create conflicts of interest, among other things, these and similar material facts should probably be disclosed to potential investors.

Conclusion

To sum up, this article analyzed recent enforcement activity by state and federal securities regulatory agencies. Be sure to stay tuned for our next article, which will focus on developments in commodities and derivatives regulation and the recent activities of the CFTC!


 

David Felsenthal is a partner at Clifford Chance, resident in the firm’s New York office. His practice focuses on trading, structured transactions, fintech and financial regulation. He has worked extensively on a range of derivatives – including derivatives linked to credit, foreign exchange, interest rates and equities – and other financial transactions, such as structured securities, repos and securities lending. His Fintech experience involves blockchain, shared ledgers and Regtech.

 

 

 

 


Jesse Overall is an associate at Clifford Chance. He represents issuers and underwriters in public and private initial and follow-on offerings of equity and debt securities, banks and hedge funds in secondary market par and distressed debt trading, and sponsors of and liquidity providers to securitization vehicles in connection with transactions and regulation applicable to their activities. While in law school at Georgetown, Jesse served as a two-semester intern at the CFTC, in the Divisions of Swap Dealer and Intermediary Oversight and Enforcement, and as a two-semester intern at the SEC, in the Division of Corporation Finance and in the Office of International Affairs.

 

 

 

In early March the SEC released a Public Statement warning online token trading platforms that they may be unregistered securities exchanges. For a thorough analysis of the SEC’s Public Statement, see our Clifford Chance briefing: More Than A Token Risk – ICO Trading Platforms and Promoters In SEC Crosshairs.

References
https://www.coindesk.com/sec-chief-not-icos-bad/
https://ag.ny.gov/press-release/ag-schneiderman-launches-inquiry-cryptocurrency-exchanges
https://www.wsj.com/articles/sec-launches-cryptocurrency-probe-1519856266
Complaint, SEC v. Jon E. Montroll and Bitfunder, Docket 1:18-cv-01582 (S.D.N.Y. Feb. 21, 2018) https://www.sec.gov/litigation/complaints/2018/comp-pr2018-23.pdf
https://www.cliffordchance.com/briefings/2018/03/more_than_a_tokenriskicotradingplatform.html
Complaint, SEC v. Sohrab Sharma and Robert Farkas, Docket 1:18-cv-02909 (S.D.N.Y. Apr. 2, 2018)(“Centra Complaint”) https://www.sec.gov/litigation/complaints/2018/comp-pr2018-53.pdf 
  Centra Complaint, paragraph 49, page 12.
  Id., paragraph 48, page 12.
https://www.sec.state.ma.us/sct/current/sctcryptocurrency/cryptocurrencyidx.htm
Consent Order, In the Matter of Sparkco, Inc., d/b/a Librium, Docket No. E-2018-0017 (Mar. 27, 2018) (hereafter “Sparkco Consent Order”), https://www.sec.state.ma.us/sct/current/sctcryptocurrency/MSD-Sparkco-Consent-Order-E-2018-0017.pdf
Sparkco Consent Order, paragraph 13.
See, e.g., Risdall v. Brown-Wilbert, Inc., 753 N.W.2d 723, 730-31 (Minn. 2008); Brown v. Earthboard Sports USA Inc., 481 F.3d 901, 912 (6th Cir. 2007). 
  Sparkco Consent Order, paragraph 24.
  See 950 MASS.CODE REGS. § 14.402(B)(13)(i) (2017).
 Complaint, In the Matter of Caviar and Kirill Bensonoff, Docket No. E-2017-0120 (Jan. 17, 2018)(the “Caviar Complaint), ttps://www.sec.state.ma.us/sct/current/sctbensonoff/Administrative-Complaint-E-2017-0120.pdf 
  Caviar Complaint, paragraph 46 and fn. 5.
 Caviar Complaint, paragraph 48.
 Caviar Complaint, paragraphs 51-54.
 Texas State Securities Board, WIDESPREAD FRAUD FOUND IN CRYPTOCURRENCY OFFERINGS, (Apr. 10, 2018) https://www.ssb.texas.gov/sites/default/files/CRYPTO%20SWEEP%20report%20April%2010%202018%20FINAL.pdf 
 Emergency Cease and Desist Order, In the Matter of USI-Tech Limited, Order No. ENF-17-CDO-1753 (Dec. 20, 2017), at 2.
Emergency Cease and Desist Order, In the Matter of LeadInvest, Order No. ENF-18-CDO-1760 (Feb. 26, 2018).
Emergency Cease and Desist Order, In the Matter of Financial Freedom Club, Inc., d/b/a Millionair Mentor University, 911MoneyStore, Inc., et al., Order No. ENF-18-CDO-1761 (Apr. 5, 2018).
Emergency Cease and Desist Order, In the Matter of DavorCoin, Order No. ENF-18-CDO-1757 (Feb. 2, 2018).
Emergency Cease and Desist Order, In the Matter of BitConnect, Order No. ENF-18-CDO-1754 (Jan. 4, 2018).
TSSB Report, at 11-13.
Emergency Cease and Desist Order, In the Matter of R2B Coin, Order No. ENF-18-CDO-1756 (Jan. 24, 2018), at 4.
TSSB Report, at 7.
TSSB Report, at 11.

Bad News: SAFTs May Not Be “Compliant” After All

The Securities & Exchange Commission (SEC) has reportedly sent a wave of subpoenas and information requests to companies engaged in Initial Coin Offerings (ICOs). The SEC scrutiny is perhaps not surprising, given that, as Crowdfund Insider writes, “if you invest in an ICO, the play is to speculate on the price of the crypto once it is traded on a cryptocurrency exchange.”¹  The Wall Street Journal has pointed out that SEC scrutiny has focused particularly on the use of “simple agreements for future tokens”, or SAFTs², a point which Coindesk confirmed, quoting a reportedly knowledgeable source, who stated: “The SEC is targeting SAFTs.”³ 

The irony is that SAFTs were created to reduce regulatory risk for ICO issuers, as reflected in the subtitle of the white paper introducing the SAFT concept, “Toward a Compliant Token Sale Framework”.4  Some of the largest ICOs of all time – such as the ongoing ICO of Telegram, which has so far raised $850 million, with a potential target of $2.5 billion5, and that of Filecoin in 2017, which raised $257 million6 – have utilized SAFT structures for precisely that reason.  This article identifies sources of legal and regulatory risk that both SAFT contracts as well as the “utility tokens” issued in their second stage may be securities under U.S. law. 

The SAFT Argument

In The SAFT White Paper, SAFTs were promoted as a way for ICO issuers to comply with U.S. securities laws by selling SAFTs only to initial purchasers who were accredited investors, then allowing them to freely re-sell the subsequently-issued utility tokens to retail investors following the network’s completion.7

The rationale for this legal alchemy purportedly lies in the SAFT’s structure.  The SAFT itself is a security.  It is a contract giving the purchaser the right to receive the issuer’s tokens that will be issued in the future, and is sold to accredited investors in a Rule 506(c) private offering, for which the issuer files a Form D.  The issuer then uses the proceeds raised by the SAFT sale to finance the development of its software network.  Once development is completed, the issuer issues and delivers now fully-functional utility tokens, useable on its network, to the original SAFT holders.  SAFT proponents argue that the tokens are not securities and therefore purchasers can freely re-sell the utility tokens to retail investors without being deemed to have facilitated an unregistered securities offering, acted as unregistered broker-dealers or violated mandatory holding periods, while intermediaries – such as trading platforms listing such tokens for trading – would not have an SEC registration obligation.

The SAFT’s proponents argue that post-completion utility tokens that have a functional use on a software network would not be securities, even though the initial SAFT contracts would be.  When the SAFT is sold, no network exists, meaning that whether there will ever be a network depends solely on the issuer’s future managerial and entrepreneurial efforts in using the proceeds raised by the SAFTs’ sale to develop the network.  However, when network development is completed, the utility tokens issued following completion purportedly do not rely on the managerial or entrepreneurial “efforts of others” to derive their value.

Instead, the tokens’ value arises from one of two sources, neither of which, proponents argue, flunk the Howey test.  First, the value of functioning utility tokens does not derive from their investment potential but rather from the value offered by their consumptive use as, e.g., coupons redeemable for goods and services from the issuer.  As Filecoin’s Private Placement Memorandum for its SAFT contracts put it:

Filecoin is a utility token that has a specific consumptive use – i.e. it allows participants in the Filecoin Network to obtain file storage, and make file storage available, on a distributed network… Due to the nature of Filecoin, we do not think it should be considered a “security”.8

Second, even if utility token holders expect to derive profit from their value as investments, the “essential” influences on such expectations are commodity-like market forces affecting industry-specific supply and demand, the same way forward sale contracts for sugar are influenced by the dynamics of the world sugar market, not expectations based on the issuer’s future managerial or entrepreneurial efforts. 

The SEC’s Stance on Utility Tokens

In the months since the release of The SAFT White Paper, the SEC has made a number of public statements that seem directly targeted at the SAFT model and its reliance on the argument that utility tokens are commodities, not securities.

a) Munchee Enforcement Action

In the SEC’s most high-profile enforcement actionIn the Matter of Munchee, Inc.9 – alleging registration violations against a utility token issuer, the SEC was not persuaded that the purported utility tokens were not securities.

The SEC made two distinct sets of arguments. First, the SEC argued they effectively were not bona fide utility tokens, because they were not marketed to persons in the restaurant industry, such as consumers who would have used them to pay for food purchases or to increase their ranking (“tier”) as restaurant reviewers, or restaurants who would have used them to pay for advertising targeting such consumers, but rather were specifically targeted at financial investors on social media and message boards catering to Bitcoin and cryptocurrency investment. 

Agents acting on behalf of the issuer touted the tokens’ financial performance relative to other cryptocurrency investments.  The issuer promised to maintain secondary markets on which such investors could re-sell its tokens by listing them on a U.S.-based exchange within 30 days of their sale, long before the network had been built, and to take action to increase the tokens’ value, such as by periodically “burning” them (taking out of circulation), to reduce their supply.  The issuer promised that profits would come, not from using the token to participate in the Munchee eco-system (such as by getting discounts on meals), but rather from passively holding the tokens, consistent with their being investments.  At the time they were sold, the Munchee tokens could not be used to buy goods or services as no network had been built yet.

Second, even if they had been bona fide utility tokens, the expectation of profits likely would have stemmed from the issuer’s managerial and entrepreneurial efforts in hiring persons to design and write the network’s code, attracting and retaining a nexus of willing participants (restaurants and reviewers) through promotional efforts targeting them, supporting a secondary market for the tokens and reducing the number in circulation, and – in general – creating a critical mass around which an eco-system could form; once built, the issuer would then maintain the network on an ongoing basis, given it was not open-source. 

Even if the increase in the tokens’ value was commodity-like –, i.e. due to a rise in token usage demand compared to a fixed10 token supply – the key factor in creating the conditions necessary for demand to rise in the first place (such as there being a network and an eco-system of participants at all in which the tokens could be used), was due to the issuer’s managerial and entrepreneurial efforts.  In the SEC’s view, the issuer’s role setting up the eco-system could possibly be enough by itself, notwithstanding the tokens’ marketing, to satisfy the “efforts of others” prong of the Howey test and thus independently cause the tokens to be securities.

b) SEC Chief Accountant Wesley Bricker’s “Claim Against” Test

We would like to draw readers’ attention to is an important programmatic statement made by a key SEC official that, curiously, appears to have escaped press coverage and market attention.  On December 4, 2017, SEC Chief Accountant Wesley Bricker articulated a key test11 for classifying distributed ledger-based assets, defining two terms – “token” and “coin”.  He stated that the term “token” refers to “a claim against an entity (or against its assets, cash flows, residual value, [or the entity’s] future goods or services…)”.  Being designated a “token” means that the instrument may be a security

On the other hand, Chief Accountant Bricker defined “coins” as being “a certain feature of a distributed ledger software program…. [that] may be exchanged among the parties.”  In other words, coins serving merely as an exchangeable unit of account or store of value, without representing a claim against any entity or entity’s assets – like Bitcoin, which is famously “not backed by anything”12 – would be “coins” under SEC Chief Accountant Bricker’s classification scheme, not at risk of being securities.  This matches Bitcoin’s real-life regulatory posture:  both the SEC and the CFTC have publicly stated that Bitcoin is not a security, but a commodity.13

Our view – additional reasons for caution

2) Timing of utility token issuer’s efforts

Regarding The SAFT White Paper’s argument about the timing of the token issuer’s managerial efforts, we refer the reader to the able discussion of the issue contained in Research Report #1: Not So Fast—Risks Related To The Use Of A “SAFT” For Token Sales, by the Cardozo Blockchain Project (“The Cardozo Report”).  The Cardozo Report’s basic conclusion is that there is a lack of meaningful support in existing law for The SAFT White Paper’s distinction between a utility token issuer’s pre-completion, pre-token-issuance efforts (which involve creating the software network) and the issuer’s post-completion, post-token-sale efforts (none, other than maintenance) when conducting a securities analysis.  The overwhelming weight of authority holds that there is no such pre- and post-issuance distinction for Howey “efforts of others” purposes.  Pre-issuance efforts by the issuer flunk the Howey test just as much as post-issuance efforts do.

The Cardozo Report’s authors found that the only existing case adopting the approach advocated by SAFT proponents is the D.C. Circuit’s decision in SEC v. Life Partners, Inc.  Yet Life Partners, which involved viatical settlement contracts, presented very peculiar circumstances and, in any case, has been rejected by virtually every other court to consider the issue, as well as the SEC. 

2) The overall structure of the SAFT arrangement indicates that the utility tokens will almost always be securities

The fundamental issue with the SAFT construct is, if utility tokens are just tokenized representations of physical assets, why is there a need to pre-sell them using a SAFT structure?  We believe that the role of the issuer in transforming nothing into something by building from scratch the network on which utility tokens can be used, using the proceeds reaped from the sale of SAFTs, is the fundamental structural problem of the SAFT model from a securities regulatory perspective. 

Simply put, a SAFT arrangement is an investment contract whose value depends on how successful an issuer is in constructing a software network.  Issuance of tokens is the final stage of an investment contract-type relationship.  Much had to happen before the utility tokens became useable –  the issuer had to first actually build the network, the costs of which were financed with the proceeds of a prior capital raise (the SAFT sale).  Investors play a well-recognized role in such an arrangement – “one of providing capital with the hopes of a favorable return.”

Without the issuer’s efforts in first building the network on which the tokens can be used, the tokens have no value of any kind.  Any value that the utility tokens have, before a network on which they can be used exists, can only be value that is derived from speculative expectations investors have that the issuer will later be successful in building a network that doesn’t currently exist and won’t and can’t exist except through the issuer’s entrepreneurial activity.  This is a purely speculative investment motive, of the same kind that underlies the purchase of any security, and it depends on an assessment of the issuer’s management team. 

Before the network is built (or has reached its final stage), the question is, will the issuer be able to overcome technical hurdles?  In the future, will increased competition interfere with the issuer’s ability to attract or retain a sufficient critical mass of participants needed to have a functioning ecosystem?  In the future, will the issuer’s product be sufficiently differentiated or desirable, or its technology sufficiently superior, compared to the competition, that it will survive competitive pressures?  When SAFTs are sold, the issuer’s network may not have a history of generating any revenues at all, let alone profits net of expenses.  In the future, will the issuer succeed in the quest to generate revenues and achieve profitability?  Questions of this nature affect an investor’s willingness to buy the issuer’s SAFTs and to receive in return speculative future tokens for something that doesn’t yet and may not ever be worth anything when it does exist.  These are also the exact same types of questions that investors ask themselves before they buy stock or bonds.

There is endless precedent proving that a financial instrument whose value arises from expectations regarding the success or failure of the issuer’s entrepreneurial efforts is a security, regardless of the form or purported label applied to the financial instrument. This holds equally true where the instruments are contracts of sale for commodities.  For instance, in Glen-Arden Commodities, Inc. v. Constantino, which involved a promoter’s sales of Scotch whiskey warehouse receipts, the promoter would, among other things, utilize its expertise in selecting the most profitable type and quality of whiskey to be purchased which would permit investors to “double their money” in four years.  The promoter argued that “they were engaged in the sale of commodities”, not securities, and thus, were not subject to SEC jurisdiction. The court framed the issue as:

whether the customers were in fact purchasing simply warehouse receipts, akin to a commodity future, or whether, in light of the economic reality and the totality of circumstances surrounding the sales here, the customers were making an investment… [in] an ‘investment contract’.

It found that the investments were securities because the actions of the promoters, including the exercise of the promoters’ expertise in selecting which whiskey to purchase from the standpoint of optimum profitability, involved “services absolutely necessary to the turning of the promised profit”, and the investor had “entrust[ed] the promoters with both the work and the expertise to make the tangible profit pay off.”  As discussed above, these are the sort of services that issuers of SAFTs are expected to render during the gap between the sale of the SAFTs, at which time no network exists at all, and the completion of the network, at which point the utility tokens will be issued.  Only if the issuer succeeds in overcoming technical hurdles and building the network, and the network succeeds in overcoming competition, will the tokens be valuable.  Without the issuer’s indispensable efforts to build a network on which the tokens can be used and defeating competition, the tokens would be completely worthless – just as, in another commodity contracts case that the court deemed to constitute securities, Continental Market Corp. v. Sec. & Exch. Comm’n, “[i]f the structure collapsed then the purchasers would have little more than a bad investment.”

Conclusion

This article set out to identify sources of legal and regulatory risk that both SAFT contracts as well as the “utility tokens” issued in their second stage may be securities under U.S. law.  To recap the arguments made in this paper:

  • the analysis contained in the SEC’s Munchee enforcement action shows that the way the SEC interprets the term “efforts of others” for Howey purposes covers utility tokens,
  • the arguments from The Cardozo Report show that there is no meaningful support in securities jurisprudence for making a distinction between an issuer’s pre-utility-token-issuance and post-utility-token-issuance entrepreneurial efforts, and
  • an investor’s willingness to purchase SAFTs (at a time when no network exists on which utility tokens could be used) is based entirely on the expectation that the issuer will successfully utilize the proceeds of the SAFT sale to develop a network on which utility tokens can be used and that will overcome competition (and that such tokens have no value unless the investor has such an expectation).

When attempting to decipher why the SEC might consider SAFT contracts and their associated utility tokens to be securities, and why the agency reportedly sent subpoenas to so many ICO market participants, token issuers, and even their law firms, we believe that the above arguments offer a good starting point. 

By and large, existing law does not appear to allow SAFTs, or their later-issued utility tokens, to escape regulation as securities or compliance with the securities laws.  Of course, given the recent Congressional attention to the issue, existing law may change, or the SEC may voluntarily decide to establish some kind of remediation program for SAFT offerings that have already closed.  But until and unless existing law does change, potential SAFT issuers will need to address the arguments enumerated above in considering their options.


 

David Felsenthal is a partner at Clifford Chance, resident in the firm’s New York office. His practice focuses on trading, structured transactions, fintech and financial regulation. He has worked extensively on a range of derivatives – including derivatives linked to credit, foreign exchange, interest rates and equities – and other financial transactions, such as structured securities, repos and securities lending. His fintech experience involves blockchain, shared ledgers and regTech.

 

 

 

 


Jesse Overall is an associate at Clifford Chance. He represents issuers and underwriters in public and private initial and follow-on offerings of equity and debt securities, banks and hedge funds in secondary market par and distressed debt trading, and sponsors of and liquidity providers to securitization vehicles in connection with transactions and regulation applicable to their activities. While in law school at Georgetown, Jesse served as a two-semester intern at the CFTC, in the Divisions of Swap Dealer and Intermediary Oversight and Enforcement, and as a two-semester intern at the SEC, in the Division of Corporation Finance and in the Office of International Affairs.

 

 

 


 

1 https://staging-crowdfundinsider.kinsta.cloud/2018/03/129341-us-crowdfunding-platforms-will-become-broker-deals-may-become-atss/
2 https://www.wsj.com/articles/sec-launches-cryptocurrency-probe-1519856266?mod=searchresults&page=1&pos=1
3 https://www.coindesk.com/sec-going-saft/
4 https://saftproject.com/static/SAFT-Project-Whitepaper.pdf
5 https://www.nytimes.com/2018/03/04/technology/telegram-initial-coin-offering.html
6 https://www.coindesk.com/257-million-filecoin-breaks-time-record-ico-funding/
See fn.4, supra.
8 https://coinlist.co/assets/index/filecoin_index/Protocol%20Labs%20-%20SAFT%20-%20Private%20Placement%20Memorandum-bbd65da01fdc4a15219c49ad20fb9e28681adec9fae744c41cccd124545c4c73.pdf , at 14.
9 https://www.sec.gov/litigation/admin/2017/33-10445.pdf
10 Of course, Munchee’s promise to engage in an active monetary policy by “burning” tokens does not resemble a passive commodity. 
11 https://www.sec.gov/news/speech/bricker-2017-12-04
12 https://www.coindesk.com/forget-gold-bitcoin-is-backed-by-time/
13 To our knowledge, to date, Bitcoin is the only such distributed ledger-based asset to have been so recognized.
14 Published November 21, 2017, and available online at https://cardozo.yu.edu/sites/default/files/Cardozo%20Blockchain%20Project%20-%20Not%20So%20Fast%20-%20SAFT%20Response_final.pdf
15 87 F.3d 536 (D.C. Cir. 1996).
16 Continental Market Corp. Sec. & Exch. Comm’n, 387 F.2d 466, 470 (10th Cir. 1967)
17 493 F.2d 1027,1034-35 (2d. Cir. 1974).
18 Id., at 1034.
19 Id.
20 Id. at 1035.
21 Supra fn.16, at 471.
22 See, e.g., Liquid M Capital, Petition for Rulemaking Regarding ICO Remediation, available online at https://www.sec.gov/rules/petitions/2018/petn4-719.pdf

 

A Tale of Two Cities: SEC & CFTC Heads Testify Before the Senate Banking Committee

Truly, it was a tale of two cities.

On February 6, 2018, the U.S. Senate Banking Committee held a hearing on the oversight role of the Securities and Exchange Commission (SEC) and the Commodity Futures Trading Commission (CFTC) in respect of virtual currencies like Bitcoin and Initial Coin Offerings (ICOs). The SEC views ICOs as being similar in nature to the securities it traditionally polices, while the CFTC sees markets for virtual currencies like Bitcoin as commodities subject to certain forms of its jurisdiction.

Although the basic categorization scheme is clear (ICO = SEC; virtual currency = CFTC), detailed practical criteria for distinguishing between what products fall into which category was not discussed in the hearing. The general rule for differentiating a commodity from a security is that substance prevails over form in the analysis, and so, according to Chairman Clayton “simply calling something a ‟currencyˮ or a currency-based product does not mean that it is not a security.”

[easy-tweet tweet=”the basic categorization scheme is clear #ICO = SEC; virtual currency = CFTC”]

A Tale of Two Cities

Based on their testimony at the hearing, one fact became quickly apparent: SEC Chairman Clayton views ICO regulation through a very different lens compared to that through which CFTC Chairman Giancarlo views the regulation of virtual currency – hence, the “tale of two cities” reference above.

To the extent these deep philosophical differences among agency heads shape – or are reflective of an internal consensus regarding – policy at their respective institutions, they will likely have major consequences for the markets in which these different products are traded.

1. Intrinsic Value

No question surrounding Bitcoin is as divisive as the question of whether Bitcoin has any intrinsic value at all – is it effectively worthless, or does it have a minimum value higher than zero?

For the leaders of the SEC and CFTC, differing perceptions of intrinsic value arguably affect their assessment of whether Bitcoin as a whole is a fundamentally positive, or a fundamentally pernicious, phenomenon – and thus, whether it should be regulated with a light or a heavy touch. The question was posed by Senator Richard Shelby, who asserted that;

“these cryptocurrencies lack intrinsic value… I don’t know where the bottom [value] is,” then asked for comment. Chairman Clayton basically agreed, stating, “a lot of smart people think there is some value for cryptocurrency, [based on] international exchange… I’m not seeing those benefits manifesting themselves in the market yet.”

However, Chairman Giancarlo disagreed, pointing out that “some economists posit that there is a relationship between Bitcoin value and the difficulty, or cost, of mining… there is some sort of floor, the level set is not zero.”

Not surprisingly, these different value judgments regarding whether Bitcoin is an essentially worthless fad, or not, arguably reflect themselves in differing assessments of how heavy-handed the regulation of digital assets needs to be, as will be discussed below. 

2. Clayton

SEC Chairman Clayton is of the view that ICOs are nothing new under the sun. In general, he believes tokens issued in ICOs constitute securities under the existing federal securities laws and do not require Congress to grant new powers to the SEC via new legislation because the agency already possesses the authority to regulate them under existing law. Most ICOs are. Chairman Clayton’s remarks, taken as a whole, suggest that he considers the use of blockchain technology in ICOs to be a case of “old wine in new bottles” – in other words, a cosmetic change involving novel facts which does not affect the legal substance of an ICO transaction, which is typically an issuance of securities. 

Chairman Clayton’s testimony demonstrates that he does not view ICOs as being a fundamentally new phenomenon not captured by existing law, and conveys his visceral displeasure and frustration at the way that market participants and certain so-called “gatekeepers” such as securities lawyers and accountants have frequently reached contrary (mistaken, in his view) conclusions on this question:

“Some say… the law is not clear.I do not buy that for a moment… [E]very ICO I have seen is a security.”

[easy-tweet tweet=”Some say… the law is not clear. I do not buy that for a moment… Every ICO I have seen is a security – Jay Clayton” template=”light”]

Thus, for SEC Chairman Clayton, the typical ICO is a securities offering. And because no ICO has ever registered with the SEC, the implication is that the typical ICO is illegal under the federal securities laws (unless a registration exemption applies, which would require marketing restrictions that ICOs to date frequently have not observed). Thus, the failure to register by itself would be an avenue to pursue enforcement actions and impose liability for registration failures against the entrepreneurs or sponsors responsible for launching the ICO – affirmative fraud would not be necessary.

Indeed, this is arguably the lesson of the SEC’s Munchee enforcement action in December 2017 – despite the absence of fraud, the SEC halted the ICO because of its failure to register with the SEC. And such a registration failure could also result in liability for intermediaries who facilitate an ICO but fail to themselves register with, and be supervised by, the SEC as securities exchanges or broker-dealers.

Given the universality of Chairman Clayton’s stance, that virtually all ICOs to date have likely been conducted illegally, Senator Mark Warner actually asked about whether the SEC intends to disturb the finality of ICOs that have already been completed:

“certain ICOs, the SEC has not stopped, others they have stopped… [a]re you going to go back and review the ones that have already gone forward?”

Chairman Clayton effectively dodged the question, saying he counted on “gatekeepers” to do their job, but did not address whether he intends to pursue enforcement action against already-completed ICOs.

[easy-tweet tweet=”Chairman Clayton did not address whether he intends to pursue enforcement action against already-completed #ICOs”]

3. Giancarlo

By contrast, CFTC Chairman Giancarlo’s approach appears both philosophically and practically very different from that taken by SEC Chairman Clayton, in three major ways.

First, on a philosophical level, Chairman Giancarlo – unlike Chairman Clayton – believes virtual currencies like Bitcoin, which are CFTC-jurisdictional commodities, constitute a fundamentally new asset class. Unlike ICOs, Bitcoin and other virtual currencies are not simply “old wine in new bottles.” Instead, they are, as Chairman Giancarlo remarked previously, “a commodity unlike any the Commission has dealt with in the past,” and as such a genuinely new phenomenon (not just cosmetically so, but substantively).

The second major difference between CFTC Chairman Giancarlo and SEC Chairman Clayton is the perceived need for “new thinking” – and new law. Chairman Giancarlo is of the opinion that – because Bitcoin and other virtual currencies are a genuinely new economic and financial phenomenon –  such virtual currencies’ characteristics are not captured by, and not subject to, existing law, given that existing law was not designed with their unique properties in mind, and that this jurisdictional deficit applies not just to the CFTC but to all federal regulatory agencies.

Chairman Giancarlo’s message is clear: a change in the laws is needed for the CFTC to able to comprehensively regulate the Bitcoin spot market (in which trades are for prompt delivery) the same way that it regulates the Bitcoin derivatives market (in which trades are made for future delivery or may never result in physical delivery, settling instead by cash or netting).

In derivatives markets, the CFTC can impose liability on entities for, among other things, failing to register or to obey extensive business conduct requirements. But in spot markets, it basically is restricted to policing fraud and manipulation. This affects the types of enforcement actions the CFTC can bring.  And perhaps the most consequential implication of this view is its implicit recognition that such markets are not presently illegal under existing laws – if new laws are required to regulate them, then applicable laws currently in effect could not declare them wholly illegal.

Chairman Giancarlo’s third major point of departure from Chairman Clayton is arguably his basic belief that the optimal regulatory regime for spot markets for virtual currencies like Bitcoin is one involving the lightest possible regulatory touch, with a view towards avoiding stifling the developing markets for digital assets through excessive regulation.

Unlike Chairman Clayton’s preference for declaring virtually the entire ICO market illegal and his apparent focus on policing registration and marketing violations wherever occurring, even in the absence of fraud, Chairman Giancarlo believes that a lighter touch approach is appropriate (though with enhanced protections for retail investors) for blockchain-based assets, drawing a positive parallel with the laissez faire attitude adopted by the Clinton administration and a Republican-controlled Congress during the birth of the Internet:

“Do no harm” was unquestionably the right approach to development of the Internet. Similarly, I believe that “do no harm” is the right overarching approach for distributed ledger technology.

Next Steps

The next step from here will be an inter-agency conferral between the SEC, CFTC, Federal Reserve, Treasury, Internal Revenue Service, and state banking regulators, among others, to identify gaps in their respective statutory frameworks and whether new legislation is needed. Chairmen Clayton and Giancarlo promised they would report back to Congress with the results of such conferral, and we expect potential legislative action to ensue at that future time.


 

David Felsenthal is a partner at Clifford Chance, resident in the firm’s New York office. His practice focuses on trading, structured transactions, fintech and financial regulation. He has worked extensively on a range of derivatives – including derivatives linked to credit, foreign exchange, interest rates and equities – and other financial transactions, such as structured securities, repos and securities lending. His fintech experience involves blockchain, shared ledgers and regTech.

 

 

 

 


Jesse Overall is an associate at Clifford Chance. He represents issuers and underwriters in public and private initial and follow-on offerings of equity and debt securities, banks and hedge funds in secondary market par and distressed debt trading, and sponsors of and liquidity providers to securitization vehicles in connection with transactions and regulation applicable to their activities. While in law school at Georgetown, Jesse served as a two-semester intern at the CFTC, in the Divisions of Swap Dealer and Intermediary Oversight and Enforcement, and as a two-semester intern at the SEC, in the Division of Corporation Finance and in the Office of International Affairs.

 

 


¹Jay Clayton, Chairman, Securities & Exchange Commission, Written Testimony on “Virtual Currencies: The Oversight Role of the U.S. Securities and Exchange Commission and the U.S. Commodity Futures Trading Commission”, (Feb. 6, 2018) at 5. https://www.banking.senate.gov/public/_cache/files/a5e72ac6-4f8a-473f-9c9c-e2894573d57d/BF62433A09A9B95A269A29E1FF13D2BA.clayton-testimony-2-6-18.pdf
²Press Release, CFTC Statement on Self-Certification of Bitcoin Products by CME, CFE and Cantor Exchange, (Dec. 1, 2017) http://www.cftc.gov/PressRoom/PressReleases/pr7654-17