Yesterday at the Consensus: Invest Conference in New York City, Jay Clayton, Chairman of the U.S. Securities and Exchange Commission (the “Commission”), strongly reaffirmed the guidance put forth by his agency in the last several weeks on cryptocurrencies, blockchain, and “digital asset securities”. Although the Chairman’s comments were made in his personal capacity – and not as an official statement from the Commission – during a “fireside discussion,” Mr. Clayton was clear that the Commission has reached a more definitive position on this emerging industry as laid out in the November 16, 2018 statement (the “Statement”)1 issued by the Commission’s Division of Corporation Finance, Division of Investment Management, and Division of Trading and Markets. To date, the Statement has been the agency’s most thorough and important guidance on securities regulation as it relates to blockchain and digital assets.2 Both in the Chairman’s public comments and the Statement, the Commission described its vision for security regulation as it applies to digital asset securities and also to exchanges, broker-dealers, investment advisers, and investment companies dealing in digital asset securities. In short, the Commission will seek to apply the same standards to digital asset security transactions as it does to traditional security transactions. Specifically, the Commission discussed the following three categories relating to issuing and trading digital assets:
(1) initial offers and sales of digital asset securities (including those issued in initial coin offerings (“ICOs”));
(2) investment vehicles investing in digital asset securities and those who advise others about investing in these securities; and
(3) secondary market trading of digital asset securities.
Interestingly, while not immediately apparent from the Statement, a potential, and significant, takeaway from the guidance might be the Commission’s clear demarcation of “digital asset securities” – the term the Commission appears to have settled on for digital security tokens – from other blockchain and digital assets that do not meet the definition of an “investment contract” under the Howey Test. Throughout the Statement, the Commission consistently holds that its regulatory reach extends to “digital asset securities”. The converse of this suggests that this reach does not extend to other financial applications of blockchain, such as true cryptocurrencies or smart contracts. This interpretation would be consistent with the Commission’s statements earlier this year where it noted that cryptocurrencies such as Bitcoin and Ether, and presumably those of a similar type, are not “securities”.3 Mr. Clayton also made similar comments at the Consensus: Invest Conference, although he was more measured when pressed as to whether other cryptocurrencies, such as XRP, which runs on the Ripple network, would be subject to securities regulation. As a result, the Statement should have long-standing positive impacts for cryptocurrency and blockchain participants outside of the securities realm as well.
Offers and Sales of Digital Asset Securities
In connection with the offer and sale of digital asset securities, the Commission pointed out that it has brought a number of enforcement actions involving offerings of digital asset securities. To date, these actions have principally focused on two important questions:
|(1) When is a digital asset a "security" for purposes of the federal securities laws?
(2) If a digital asset is a security, what SEC registration requirements apply?
Therefore, companies that have performed an ICO, “security token sale”, or other blockchain-driven capital raise, should consult with qualified legal counsel to engage with federal and state securities regulators and work towards a resolution that will comply with the Commission’s recent guidance.
Investment Vehicles Investing in Digital Asset Securities
The Commission also reiterated that funds and other investment vehicles that hold digital asset securities and those who advise others about investing in digital asset securities, including managers of investment vehicles, must be mindful of registration, regulatory and fiduciary obligations under the Investment Company Act of 1940 and the Investment Advisers Act of 1940. This applies even if digital asset securities are only a portion of the assets under management.
In the Statement, the Commission pointed to its order against Crypto Asset Management, LP from September of this year5, where the manager of a hedge fund that specialized in investing in digital assets, including digital asset securities, failed to register himself as an investment adviser or the fund as an investment company. . Ultimately, the manager was issued a cease-and-desist and fined $200,000.00. Accordingly, all funds seeking to acquire interests in any digital asset should seek legal counsel experienced in these issues.
Trading of Digital Asset Securities
The Commission specifically addressed secondary market trading of digital asset securities, stating that generally such activities require registration as a national securities exchange or registration as a broker or dealer, as those terms are defined under the federal securities laws, unless there is an exemption. For the last several years, questions surrounding secondary market trading have created market uncertainty in the digital asset industry.
A. Exchange Registration
A platform that offers trading in digital asset securities and operates as an “exchange” (as defined by the federal securities laws) must register with the Commission as a national securities exchange or be exempt from registration. Earlier this month, the Commission issued a cease-and-desist order against Zachary Coburn, pursuant to Section 21C of the Securities Exchange Act of 1934, for operating an unregistered exchange, which provided an online portal for trade executions and settled trades on the back-end through a blockchain smart contracts system.6
The Commission found that any entity that provides a marketplace for bringing together buyers and sellers of securities, regardless of the applied technology, must determine whether its activities meet the definition of an exchange under the federal securities laws. Exchange Act Rule 3b-16 provides a functional test to assess whether an entity meets the definition of an exchange under Section 3(a)(1) of the Exchange Act. An entity that meets the definition must register with the Commission as a national securities exchange or be exempt from registration, such as by operating as an alternative trading system in compliance with Regulation ATS.
Entities using blockchain or distributed ledger technology for trading digital assets should carefully review their activities on an ongoing basis to determine whether the digital assets they are trading fall under the Commission’s definition of “securities” and whether their activities or services cause them to satisfy the definition of an exchange. An entity engaging in these types of activities should also consider other aspects of the federal securities laws (and other relevant legal and regulatory issues) beyond simply exchange registration requirements.
B. Broker-Dealer Registration
The Commission also stated that an entity that facilitates the issuance and secondary trading of digital asset securities may also be acting as a “broker” or “dealer” that is required to register with the Commission and become a member of a self-regulatory organization such as FINRA. SEC-registered broker-dealers are subject to legal and regulatory requirements that govern their conduct in the marketplace and that provide important safeguards for investors. Absent an exception or exemption, it is unlawful for any broker or dealer to induce or attempt to induce the purchase or sale of any security unless such broker or dealer is registered with the Commission.
Any company looking to potentially offer digital assets through an ICO or any other method such as a “securities token sale” should contact legal counsel to ensure compliance with the U.S. securities law framework.
2. As set forth in Locke Lord LLP’s prior Quickstudy, “SEC: Digital Coin, Blockchain Capital Raises are Subject to Securities Laws”, in making a determination whether a digital token or cryptocurrency is a “security”, the Commission will apply the test for “investment contracts” set forth in SEC v. W.J. Howey Co., 328 U.S. 293, 301 (1946), which has come to be known as the “Howey Test.” Specifically, a blockchain or other digital asset is a “security” if it is 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. See also Report of Investigation Pursuant to Section 21(a) of Securities Exchange Act of 1934: The DAO (Exchange Act Release No. 81207) (July 25, 2017).
5. See Crypto Asset Management, LP and Timothy Enneking, Rel. No. 33-10544 (Sept. 11, 2018) (settled order) found here.
6. See Zachary Coburn, Rel. No. 34-84553 (Nov. 8, 2018) (settled order) found here.
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