Two months into 2018, it feels a little like the calm before a regulatory storm in terms of cryptocurrency regulation. A series of pronouncements and announcements from the SEC toward the end of 2017 and beginning of 2018 gave industry insiders more clarity on what industry players (issuers, lawyers, broker-dealers, investors) can and should do going forward to stay on the legal side of cryptocurrency offerings and investments.
Recent Regulatory Guidance
Last July, the SEC issued its investigative report on DAO Tokens and concluded that the offering was a securities offering. One takeaway from the report were that irrespective of technology or terminology, ICOs are securities if they meet the hallmarks of a traditional security. Issuers therefore need to register such offerings unless a valid exemption exists. The second significant takeaway from the report was that coin exchanges that provide for trading in these securities must be registered as an alternative trading system and/or broker-dealer in order to effect any exchanges.
On December 11, SEC Chair Jay Clayton published a statement on cryptocurrencies whereby he stated that;
“…where the application of expertise and judgment is expected, I believe that gatekeepers and others, including securities lawyers, accountants and consultants, need to focus on their responsibilities.”
Then, in January, while speaking at a San Diego legal gathering, Mr. Clayton delivered a more explicit warning to lawyers who have been involved in ICOs which essentially stated that being involved in a non-compliant ICO offering may subject them to disciplinary actions for breach of professional duties.
On the same day as the December Clayton statement, the SEC halted an ICO by Munchee, Inc., a California blockchain-based food review service. The order cited the manner of sale as well as the investment intent of purchasers of the Munchee coin in its determination that the offering was an improper securities offering.
Lately, Ms. Dalia Bass, the SEC’s Director of Investment Management in January issued a letter to the Investment Company Institute whereby she stated a number of open issues that need to be resolved before there can be a mutual fund with cryptocurrency holdings. These included issues around valuation, liquidity, arbitrage and manipulation that needed resolution. The letter ought also be viewed as an open invitation to the investment management industry to engage with the SEC collaboratively in order to resolve such issues.
What May Lie Ahead
As the price of Bitcoin is now 45% to 55% down from its recent December highs, public interest in ICOs and cryptocurrency in general has correspondingly waned. That may be an important factor in ICOs that target non-accredited investors who may be more easily impressed by whitepapers and the prospects of getting rich quick by getting in on ICOs they have little understanding of and have generally done no diligence otherwise. So, more coin offerings are going down the private placement route, targeting accredited investors. The regulators have less inclination to protect investors who are accredited and have taken, so far, a rather stand-offish approach to regulation in these private transactions.
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With the downturn of the flow of security ICOs targeting non-accredited investors, the SEC can take a deliberate approach to regulation. However, too much deliberation is not good either.
Existing regulatory regimes seem ill-suited in many ways to the distributed ledger nature of cryptocurrency and blockchain. In particular, there are open questions on how valuation, custody and AML/KYC interplay in this new industry. While those questions are being deliberated, innovation in investment products like mutual funds and other collective investment vehicles are being held up. As stated in the Dalia Bass Letter in January, the SEC has stated that they are not inclined to see any more new registrations of fund offerings with cryptocurrency holdings until these issues are resolved.
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Fortunately, the SEC has also struck a collaborative tone in fashioning solutions to open issues.
In her letter to the Investment Company Institute, Ms. Bass publicly asked for industry engagement in resolving open issues that are holding up innovation in the mutual funds space.
But while at the same time as extending a carrot to the industry that the SEC wants to collaborate, the SEC has also warned not only issuers of cryptocurrency and other investments, but also the lawyers and other service providers and intermediaries, that they will be held accountable personally for facilitating offerings.
Jay Clayton, at the legal gathering in San Diego in January stated the following:
“First, and most disturbing to me, there are ICOs where the lawyers involved appear to be, on the one hand, assisting promoters in structuring offerings of products that have many of the key features of a securities offering, but call it an “ICO,” which sounds pretty close to an “IPO.” On the other hand, those lawyers claim the products are not securities, and the promoters proceed without compliance with the securities laws…
Second are ICOs where the lawyers appear to have taken a step back from the key issues – including whether the “coin” is a security and whether the offering qualifies for an exemption from registration – even in circumstances where registration would likely be warranted. These lawyers appear to provide the “it depends” equivocal advice, rather than counseling their clients that the product they are promoting likely is a security. Their clients then proceed with the ICO without complying with the securities laws because those clients are willing to take the risk.
With respect to these two scenarios, I have instructed the SEC staff to be on high alert for approaches to ICOs that may be contrary to the spirit of our securities laws and the professional obligations of the U.S. securities bar.”
Clearly, the message is that lawyers and other service providers need to make an assessment of the likelihood of SEC enforcement action towards not only an issuer but also against themselves.
Are Utility Token Issuances Still Possible?
Can a coin today still be utility token but not a security? Theoretically, yes, but the SEC has indicated that the manner of sale, investment objectives of purchasers, and actual usefulness to the purchaser are all considerations they will use when determining if there was an unlawful securities offering and whether to bring an enforcement action.
In the recent Munchee proceeding;
“the company and other promoters emphasized that investors could expect that efforts by the company and others would lead to an increase in value of the tokens. The company also emphasized it would take steps to create and support a secondary market for the tokens. Because of these and other company activities, investors would have had a reasonable belief that their investment in tokens could generate a return on their investment.”
The marketing model of many publicly-marketed ICOs with the use of social media like Twitter, forum postings, and targeted email and website advertising introduces risks of the offering being deemed a securities offering. Proceeding down a similar path for any utilities token offering should be done so with the Munchee order in mind.
There’s an open question mark on coin forks. These do not seem to fit the mold of securities offerings and are not generally treated as such. Like other cryptocurrencies, the CFTC takes the position that they are commodities; their jurisdiction is implicated when cryptocurrencies are used in a derivatives contract, or if there is fraud or manipulation involving interstate commerce. Yet, many (maybe most) investors who hold and later trade newly created coins via forking do so for investment rather than their use or utility. This seems to imply that such coins are subject to either SEC or CFTC regulation, or both.
We should expect further guidance on this from the regulators as the industry matures.
A Welcome Path Forward
The regulators have asked the industry for engagement on solving unique issues pertaining to blockchain and cryptocurrencies. That should be a welcome opening for all serious players to engage in the development of new regulations or revision of existing regulations. On the other hand, the regulators have warned that all involved, issuers and ancillary participants such as lawyers and other service providers, may be liable for enforcement action where an offering or investment is not done according to applicable securities laws. The path forward should be to engage with the regulators, and to educate them on emerging uses of blockchain and cryptocurrency.
Philip Liu is counsel in Manatt, Phelp & Phillips’ corporate and finance practice in Los Angeles. With over 20 years of experience in the financial sector, Philip advises companies, banks and financial institutions on legal matters concerning asset management, securities and broker-dealer regulation, digital finance (marketplace lending, crowdfunding, blockchain and cryptocurrencies), commodities and derivatives, and structured products.