On March 7, 2018, the Securities and Exchange Commission (SEC) issued a public statement warning that cryptocurrency coin exchanges were possibly operating as unlawful online trading platforms¹. The SEC staff noted that “many online trading platforms appear to investors as SEC-registered and regulated marketplaces when they are not.”
The public statement follows a series of warnings and enforcement actions in 2017 and early 2018 from the regulator². Very recently, the SEC reportedly issued subpoenas to over 80 parties involved in initial coin offerings demanding documents related to how the offerings were marketed and to whom³.
Three investor areas of concern
The latest public statement addresses both investors and operators of online trading platforms (a/k/a “coin exchanges”). On the investor front, the SEC has identified three areas of concern: firstly, that many platforms refer to themselves as “exchanges,” which may lead to investor misimpression that they are regulated or meet the regulatory standards of a national securities exchange; secondly, that the digital assets (a/k/a “coins”) available for trading on an online trading platform may not be of sufficient quality like the securities listed on a national securities exchange; and thirdly, the so-called order books and bid/ask spread quotations provided by an online trading platform may not have the same integrity as that provided by a national securities exchange.
Market participants warned
For market participants who operate online trading platforms, the SEC warns that such platforms that trades coins that are securities and operate as an “exchange” must register as a national securities exchange or otherwise operate under an exemption from registration, such as the exemption provided for alternative trading systems (ATSs) under SEC Regulation ATS. The SEC notes that under either scenario, additional regulatory obligations need to be considered.
In particular, the statement notes that “a national securities exchange must have rules and procedures governing the discipline of its members and persons associated with its members, and enforce compliance by its members and persons associated with its members with the federal securities laws and the rules of the exchange.”
Alternatively, an entity seeking to operate as an ATS is subject to registration with the SEC as a broker-dealer and becoming a member of the Financial Industry Regulatory Authority (FINRA). Registration as a broker-dealer subjects the ATS to a host of regulatory requirements, such as the requirement to have reasonable policies and procedures to prevent the misuse of material non-public information, books and records requirements, and financial responsibility rules, including, as applicable, requirements concerning the safeguarding and custody of customer funds and securities, and maintaining sufficient net capital reserves.
Other trading services possibly implicated
The SEC also warns that, even if not considered exchanges, certain trading services offered by market participants may implicate other registration requirements under federal securities laws, including broker-dealer, transfer agent or clearing agency registration. The statement offers, as an example, platforms that offer digital wallet service to hold or store digital assets, or transact in digital assets that are securities.
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This latest public statement from the SEC adds to the regulator’s other warnings, public statements and enforcement actions in 2017 and 2018. It is clear that the SEC is intent on exerting its authority to prevent what it deems to be illegal securities offerings, as well as secondary market trading, of cryptocurrency.
Cryptocurrencies and the blockchain technology underlying them are an emerging technology that crosses national borders easily and are oftentimes promoted as being without a centralized control structure. However, regardless of terminology and technology, the SEC has consistently warned that federal securities laws dating back to the Securities Act of 1933 and the Exchange Act of 1934 continue to apply to innovations in cryptocurrency offerings.
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Takeaway #1 – Review Current Legal Position
Any venture seeking to act as a wallet service or offering services where users store or trade cryptocurrency should consider with their legal counsel whether federal securities laws are implicated. While it is likely that all or most of the current and well-known online trading platforms have already received subpoenas for more information on their operations, even ventures not generally considered as “trading” in cryptocurrency should revisit their position in light of this latest guidance.
Takeaway #2 – Avoid “Hot Button” Terminology
In this latest public statement, the SEC has taken issue with the term “exchanges” and related terminology such as “order books” and “bid/ask spreads.” If these terms are currently used in any existing venture, they should either be avoided or else be appropriately and thoroughly explained (or disclaimed) to the reader, user or investor, to avoid any misimpression’s about such venture being a registered exchange, alternative trading system or broker-dealer.
Takeaway #3 – Review of Operations and Precautionary Measures Before the Regulators Ask
To the extent that there exists a reasonable expectation that the SEC, FINRA or other regulator may conclude any venture as being required to register as a broker-dealer, alternative trading system, or other entity requiring registration, consideration should be given as to whether additional compliance measures are needed before the regulators show up. These may include upgraded compliance manuals, supervision controls over employees (for example, to prevent insider trading and other misuse of material non-public information), and upgraded technology.
Takeaway #4 – Engaging with the SEC and Seeking Alternative Legal Advice
If a venture has not yet started operations, consideration should be given as to whether it would be beneficial to engage the SEC during the pre-launch process. In its public statements, the SEC has encouraged market participants employing new technologies in cryptocurrency and blockchain to contact the SEC for assistance in analyzing the application of federal securities laws. Where anonymity is desired, securities counsel can aid in discussions by acting as a go-between.
Finally, just as the technology of cryptocurrency and blockchain is rapidly developing, so are the legal perspectives of securities lawyers. For example, recent enforcement actions have changed the view of many outside counsels in their determination of whether a coin token is a utility coin or a security. As this space evolves technologically and legally, it would not be imprudent to seek additional legal perspectives before venturing down any particular course of action.
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.