Daniel Nathan

Partner

Washington, D.C.


Read full biography at www.orrick.com

Daniel Nathan uses his deep enforcement and regulatory experience to represent U.S. and international financial institutions and individuals before financial regulators.

With a combined 25 years as a senior enforcement official with the SEC, CFTC and FINRA, three of the country’s leading regulatory and enforcement authorities, Dan is a particularly effective advocate for those facing investigations and/or enforcement action by those regulators. He is also active in advising and representing companies who issue or transact in cryptocurrency and is co-chair of Orrick's Blockchain and Cryptocurrency group.

Daniel’s intimate knowledge of broker-dealer regulation provides clients facing SEC or FINRA examinations and enforcement investigations with experienced counsel related to broker-dealer supervisory procedures, sales practices, anti-money laundering, ETF regulation, product disclosure and supervision, and securities and broker registration. His extensive experience includes the JOBS Act and Dodd-Frank Act, and he has led extensive efforts to help foreign banks establish programs for complying with the Volcker Rule. He also represents individuals and entities facing investigations by the CFTC or derivatives exchanges.

Previously, Daniel served as the Vice President and Regional Enforcement Director of the Financial Industry Regulatory Authority (FINRA), where he oversaw 70 lawyers across 15 offices responsible for bringing up to 900 disciplinary actions annually against broker-dealer firms, registered representatives and associated persons. This included many of FINRA’s most significant nationwide enforcement actions, including actions and sweeps involving mutual fund breakpoints, structured products sales practices and supervision, and private placement due diligence and disclosure.

In his 12 years at the SEC, Daniel served as Assistant Director in the Division of Enforcement, where he supervised federal securities investigations of insider trading (including the investigation that resulted in the seminal case US v. O’Hagan), market manipulation, financial fraud and accounting misconduct. In nine years with the CFTC, he served as Deputy Director of Enforcement, with responsibility for oversight of the agency’s Enforcement Division.  In that role, he supervised significant actions regarding market manipulation, trade practices, commodity trading advisor practices and foreign exchange dealer practices.

An oft-quoted authority on complex financial, legal and business issues, Daniel is frequently sought after to speak and write on the important issues confronting financial institutions, including broker-dealer sales practices and compliance, complex products, ETFs, the Volcker Rule, derivatives, cryptocurrency, cybersecurity, and anti-money laundering. He is Co-chair of the ABA SEC Enforcement Subcommittee and a member of the Editorial Advisory Board of the Journal of Investment Compliance.

Posts by: Daniel Nathan

Playing Catch-Up: Commissioner Peirce Proposes a Safe Harbor for Certain Token Offerings

SEC Commissioner Hester Peirce has once again earned her title as “Crypto Mom” by expressing support for building a “non-exclusive safe harbor” for the offer and sale of certain cryptocurrency tokens. Peirce explained that the concept of a safe harbor is still in its infancy and did not propose a timeline for the project. Nevertheless, her support is welcome news for the industry, which can hope that her well-stated views will influence the rest of the Commission to move to adopting a separate securities regulatory framework for cryptocurrency.

We expect that the SEC will take its time in moving forward with the development and implementation of a safe harbor for token offerings. Peirce previously defended the SEC’s slow approach to crypto regulation, indicating that delays in establishing crypto regulations “may actually allow more freedom for the technology to come into its own.” Peirce is cognizant of the repercussions of moving too slowly and seems to be trying to balance the need for regulatory certainty with the need to get the regulatory framework right.

Peirce explained that in developing its crypto regulatory regime, the SEC can learn from other countries that have taken the lead in developing a regulatory framework for token offerings. For example, Peirce explained that the “nebulous” definition of a security in the U.S., coupled with the difficulty of determining the precise nature of a digital asset – is it a currency, commodity, security or derivative? – has slowed our regulatory progress. Peirce suggests looking at the approach taken by Singapore for the classification of offerings as non-securities, since Singapore does not treat every token offering as a securities offering. Similarly, earlier this month the SEC and FINRA issued a joint statement explaining that there are still unanswered questions regarding custody of digital assets that have led to delays in approving ATS applications. Peirce recommends reviewing Bermuda’s guidance on the subject because “Bermuda is one of the only jurisdictions to address the custody question in detail.”

With so many countries so far ahead of the U.S. in developing regulatory regimes for token offerings, the SEC has an abundance of approaches to review. Ideally this will speed up the development and implementation of the safe harbor. If, however, the SEC continues to drag its feet, token projects that would otherwise prefer to launch in the U.S. might be expected to continue to choose jurisdictions with clearer regulatory regimes.

The SEC’s Second No-Action Relief for Digital Tokens: Meaningful Relief or a Wolf in Sheep’s Clothing?

Pocketful of Quarters, Inc. (PoQ) is the second-ever recipient of no-action relief from the Division of Corporation Finance of the Securities and Exchange Commission for the issuance of “Quarters.” Quarters are a digital arcade token that is usable, like its conventional physical counterparts, across participating games and platforms. This no-action relief evidences a more thoughtful and sophisticated approach to the regulation of digital tokens and, in that respect, is welcome news to an industry that has been adrift since SEC Chairman Clayton’s statement in December 2017 that “[b]y and large, the structures of initial coin offerings that [he has] seen promoted involve the offer and sale of securities.” This no-action relief, though arguably unnecessary because Quarters are clearly not securities, confirms that certain classes of tokens are not subject to the requirements of the federal securities laws. Moreover, the conditions and restrictions imposed by the no-action letter on the issuance and use of Quarters are so onerous that the relief granted, while reaffirming, is not groundbreaking.

In the no-action relief, the Chief Legal Advisor to FinHub indicated that, subject to conditions, the Division would not recommend enforcement action to the Commission if PoQ offers and sells Quarters without registering the tokens as securities under Section 5 of the Securities Act and Section 12(g) of the Exchange Act. Some of the more significant conditions are:

  • The Quarters will be immediately usable for their intended purposes (gaming) at the time they are sold;
  • PoQ will restrict the transfer of Quarters through technological and contractual provisions governing the Quarters and the Quarters Platform that restrict the transfer of Quarters to PoQ or to wallets on the Quarters Platform;
  • Gamers will only be able to transfer Quarters to addresses of Developers with Approved Accounts or to PoQ in connection with participation in e-sports tournaments;
  • Only Developers and Influencers with Approved Accounts will be capable of exchanging Quarters for ETH at pre-determined exchange rates by transferring their Quarters to the Quarters Smart Contract;
  • Quarters will be made continuously available to gamers in unlimited quantities at a fixed price;
  • PoQ will market and sell Quarters to gamers solely for consumptive use as a means of accessing and interacting with Participating Games.

Considered as a whole, these conditions are so restrictive and duplicative that they raise doubt as to the necessity of the relief. For example, since Quarters will be made continuously available in unlimited quantities at a fixed price, no reasonable purchaser can expect the price of Quarters to increase and therefore cannot expect to profit from the purchase of Quarters. Accordingly, the transfer and secondary market trading restrictions are superfluous, and by highlighting them as a condition of the relief, CorpFin is effectively imposing conditions on a non-security.

Commissioner Hester Pierce raised a similar concern regarding the staff’s issuance of the first token no-action letter to TurnKey Jet, a charter jet company that sought to tokenize gift cards that could be used to charter its jet services. She stated that the offering of Turnkey tokens is so “clearly not an offer of securities that I worry the staff’s issuance of a digital token no-action letter . . . may in fact have the effect of broadening the perceived reach of our securities laws.” She continued by stating that the Turnkey no-action letter “effectively imposed conditions on a non-security.” Nevertheless, the Quarter’s no-action relief should be touted because it reestablishes the possibility of issuing a digital token that is not a security.

There are three additional aspects of PoQ’s letter requesting no-action relief that merit special attention: (i) the two-tiered token approach used by PoQ; (ii) the built-in token economics managed by a smart contract; and (iii) the condition that KYC/AML compliance reviews must be made at account initiation and on an ongoing basis.

First, Quarters are the second class of tokens that PoQ will issue, but the only one for which it sought no-action relief. PoQ conceded that the first class of tokens PoQ issued, “Q2 Tokens,” are securities, which were sold to investors through an exempt offering to raise funds to build the Quarters platform. The holders of the Q2 Tokens will benefit from the sale of Quarters by receiving, ratably, 15% of the funds collected from the sale of Quarters. This, or a similar, structure could prove beneficial to other investors that purchased tokens through an exempt offering and are now waiting for a return on their investment.

Next, the no-action relief implicitly approves the token economics of the PoQ network. According to PoQ’s letter requesting no-action relief, a portion of the funds received from the sale of Quarters will be used to compensate developers, influencers and Q2 Token holders in ETH. The funds distribution process will be managed by a smart contract. If Quarters are purchased with fiat currency, PoQ will transfer an equivalent amount of ETH to the Quarters Smart Contract upon such purchases for the purposes of such compensation.

Last, the no-action request raises, but leaves unanswered, a question pertinent to all token issuers: whether PoQ or any participant on the Quarters Platform must register with FinCEN as a money services business. Although this question is left unanswered, it appears that PoQ has built in some processes that would be required if it were a registered MSB. For example, a condition of the no-action relief states that: “to create an Approved Account, Developers and Influencers will be subject to KYC/AML checks at account initiation as well as on an ongoing basis.” In addition, the no-action request explains that purchases of Quarters through the PoQ Website “will occur via a licensed payment processor.” Similarly, purchases made through the Apple App store and Google Play store will occur via the standard payment processing solutions generally applicable to purchases made through those platforms; it is possible that this system was put in place to take advantage of one of the money transmitter exemptions such as the payment processor exemption. For the time being, however, it appears that PoQ has not registered with FinCEN; PoQ does not appear as a registered entity on FinCEN’s MSB Registrant database.

Though restrictive in its terms, the Quarters no-action relief demonstrates the SEC’s willingness to engage with token issuers and permit use of cryptocurrency outside of the SEC’s regulation, although the agency does not appear ready to give the concept free reign.

The SEC Can’t Keep Kik-ing the Crypto Can

The SEC’s Action

On June 4, 2019, the SEC sued Kik Interactive Inc. (“Kik”), a privately held Canadian company, in the Southern District of New York, alleging that Kik’s offer and sale of $100 million worth of Kin tokens in 2017 constituted the unregistered sale of securities in violation of section 5 of the Securities Act. In a nutshell, the SEC asserts that, although Kik filed a Form D exemption from registration for the offering, the Kin sale did not qualify for the exemption because the tokens were offered and sold to the general public, not exclusively to accredited investors.

Importance

This case could yield guidance from a court on whether and when tokens constitute securities, to substitute precedential law for the SEC’s pronouncements in settled enforcement actions and guidance issued by its Divisions. The SEC charges that Kin tokens are securities under the Howey test. As a result of Kik’s failure to register the tokens, the SEC alleges, investors did not receive the information from the company relevant for evaluating Kik’s claims about the potential of the investment, including current financial information, proposed use of investor proceeds, and the company’s budget. The Complaint emphasizes the reasonable expectations of “investors” in Kin that the value of their tokens would increase based upon Kik’s efforts, in terms that suggest that Kik’s statements about its projects lacked support and might even have been misleading. And although scienter is not a component of Section 5 charges, and the SEC did not charge fraud, the Complaint alleges that Kik knew or should have known that it was offering securities because, among other things: (1) the SEC had issued the DAO report that applies the Howey test before Kik began offering and selling the tokens; (2) a consultant warned Kik that Kin could be considered a security; and (3) the Ontario Securities Commission told the company that a sale to the public of Kin would constitute a securities offering. Kik’s primary defense is that Kin is not a security but a transaction currency or utility token akin to Bitcoin or Ether, which are not regulated as securities.

This appears to be the SEC’s first litigated federal action against an issuer solely for failure to register. Most registration cases have settled, and the ones that proceeded to litigation involved fraud claims in addition to failure to register. Since 2017 there have been over 300 ICO-related Form D offerings, so many companies may be directly impacted by the outcome of this case. Kik has stated that it intends to litigate through trial, and Kik and the Kin Foundation reportedly have raised a war chest of nearly $10 million (and are still seeking contributions to its defense fund).

Defenses

Although Kik has not yet answered the complaint or moved for its dismissal, the company’s position is well laid out in both a public statement from its General Counsel reacting to the filing, and an extensive Wells submission that Kik took the highly unusual step of making public. The General Counsel commented that the SEC’s complaint stretches the Howey test beyond its definition by, among other things, incorrectly assuming that any discussion of a potential increase in the value of an asset is the same as promising profits solely from the efforts of others. The Wells submission states that Kin was designed, marketed and offered as a currency to be used as a medium of exchange, taking it outside the definition of security, and that it was not offered or promoted as a passive investment opportunity. Besides extensively elaborating on its view that the Howey test is not met, Kik takes issue with “regulation by enforcement,” given the industry’s “desperate” need for guidance regarding the applicability of the federal securities laws.

Conclusion

SEC Chairman Jay Clayton stated last year that all ICOs he has seen are securities. And yet the SEC has pursued enforcement actions against only a small portion of ICOs – less than ten percent – most of which involved fraud or other intentional misconduct. It’s too soon to tell for sure, but this action might suggest that the SEC is now entering a new phase in its enforcement approach to ICOs.

NYDFS to Virtual Currency Exchange: Don’t Let the Door Hit You on Your Way Out

The New York Department of Financial Services virtual currency license is back in the spotlight after NYDFS announced that it had rejected the application of Bittrex Inc., a virtual currency exchange, to conduct virtual currency business in the Empire State. The NYDFS virtual currency license, or BitLicense, is notoriously difficult to obtain, having been granted to only 19 companies since it was implemented in July 2014. Although all BitLicense application denials are technically publicly available (but not published), the announcement of Bittrex’s application denial in such a public way is a first for the regulator. The rejection letter states that “Bittrex has failed to demonstrate responsibility, financial and business experience, or the character and fitness to warrant the belief that its business will be conducted honestly, fairly, equitably and carefully. . . .” The denial, coupled with the requirement that Bittrex immediately close up shop in New York, marks a very public rebuke of the exchange, which Bittrex met with a prompt and strongly worded response of its own.

Bittrex submitted its BitLicense application on August 10, 2015. On April 10, 2019, NYDFS publicly announced the rejection of Bittrex’s application. New York allowed Bittrex to operate in the state during the three and a half year application process under the terms of a safe harbor. According to NYDFS’s public rejection letter, the prolonged application process culminated in a four-week on-site review of Bittrex’s operations by NYDFS in February 2019. As a result of the on-site review, NYDFS rejected Bittrex’s BitLicense application based primarily on “deficiencies in Bittrex’s Bank Secrecy Act (BSA), Anti-Money Laundering (AML) and Office of Foreign Assets Control (OFAC) compliance program; a deficiency in meeting the Department’s capital requirement; and deficient due diligence and control over Bittrex’s token and product launches.” This long list of deficiencies, after such a long and laborious application process, appears at odds with the Department’s statement that “throughout Bittrex’s application process, the Department worked steadily with Bittrex” to address deficiencies in some of the very same areas found to be deficient during the February 2019 review.

According to the rejection letter, Bittrex has approximately 35,000 New York-based users who must now find a new exchange on which to trade. This is not going to be an easy task because Bittrex is a market leader listing 212 digital assets on its exchange. By way of comparison, Coinbase, which received its BitLicense in January 2017, lists six digital assets on its exchange (not including the digital assets listed on Coinbase Pro).

Within hours Bittrex responded to the public rejection with its own statement asserting that the rejection “harms rather than protects New York customers,” and stating that “Bittrex fully disputes the findings of the NYDFS” in its rejection letter. According to Bittrex, the NYDFS rejection letter contains “several factual inaccuracies” which Bittrex addresses in its response letter.

Given the public nature of this confrontation and the status of New York as a major financial hub, it is unlikely that we have heard the last of this from the parties involved. In the interim, industry participants should review the NYDFS rejection letter and Bittrex’s response, both of which provide helpful insight into the BitLicense application process and the requirements that digital asset companies have to meet if they seek to offer services in New York.

The 2019 Token Taxonomy Act: A Path to Consumer Protection and Innovation Takes Shape

We’ve previously written that the Token Taxonomy Act first introduced to Congress by Representatives Warren Davidson (R-OH) and Darren Soto (D-FL) on December 20, 2018, was a welcome legislative initiative designed to provide a regulatory “light touch” to the burgeoning digital asset industry. The bill expired, however, with the termination of the 115th Congress, leaving open the question of what any future blockchain regulatory proposals, would look like. The industry’s questions were answered on April 9, 2019 when Representatives Davidson and Soto introduced the Digital Taxonomy Act of 2019 (DTA) and the Token Taxonomy Act of 2019 (TTA) to the 116th Congress. The DTA and TTA represent expanded efforts to clarify regulation and spur blockchain innovation in the United States.

According to Representatives Davidson and Soto, the DTA is meant to add jurisdictional certainty to efforts to combat fraudulent behavior in the digital asset industry. As such, the DTA grants the FTC $25,000,000 and orders it to prepare reports on its efforts to combat fraud and deceptive behavior. The DTA also specifically carves out from its purview the authority of the CFTC to regulate digital assets as commodities subject to the Commodities Exchange Act.

The 2019 TTA, with the backing of four bipartisan representatives in addition to Davidson and Soto, is similar to last year’s model. Besides defining digital assets and exempting them from certain securities law requirements, the 2019 TTA maintains proposals to amend the Investment Advisers Act of 1940 and the Investment Company Act of 1940 so that certain regulated entities can hold digital assets. Like the 2018 version of the TTA, the 2019 TTA would also allow the sale of digital assets to qualify for the benefits of Internal Revenue Code Section 1031 like-kind exchange provisions and for the first $600 dollars of profit from digital asset sales to be tax-free.

The TTA also has important updates. The most prominent change is the definition of a “digital asset.” As we’ve previously discussed, the 2018 version of the TTA required that a digital asset’s transaction history could not be “materially altered by a single person or group of persons under common control” to qualify for exemption from securities laws. Because of the unavoidable possibility of a 51% attack, which would alter a token’s transaction history, the language created the possibility that proof of work- and proof of stake-based tokens would not be eligible for regulatory relief, thus limiting the bill’s benefits.

In the re-proposed TTA, however, the newly proposed language of Section 2(a)(20)(B)(ii) requires that the transaction history, still recorded in a mathematically verifiable process, “resist modification or tampering by any single person or group of persons under common control.” Thus, any digital asset, even those subject to 51% attacks, may be exempt from certain securities law requirements, although the language appears to require that a governance or security system underline the token’s consensus system.

Another important update is the TTA’s proposed preemption of state regulation of the digital asset industry by federal authorities. While the TTA would still permit states to retain antifraud regulatory authority, it largely strips states’ rights to regulate digital assets as securities. Representative Davidson’s press release on the bill specifically cites the “onerous” requirements of the New York BitLicense regulatory regime as a reason for the inclusion of this provision.

Critics have been quick to point out that the bills, while well intentioned, leave many unanswered questions and therefore may not provide the regulatory certainty the bills’ authors hope to effect. And even a perfect bill would face an uphill battle in getting enacted these days. But the digital asset industry should nonetheless take comfort in the growing contingent of legislators who take seriously the imperative to balance consumer protection and blockchain innovation.

Three Yards and a Cloud of Dust: SEC Staff Provides Its “Plain English” Framework to Guide Future Discussions

The SEC chose a week that saw the price of Bitcoin spike by over $700 in an hour, kicking off a rally reminiscent of the go-go days of 2017, to issue its long-awaited “plain English” guidance for determining whether a digital asset constitutes a “security” under the federal securities laws.

The SEC also unexpectedly released its first no-action letter to a company planning to issue a digital asset without registering the transaction under Section 5 of the Securities Act of 1933 and Section 12(g) of the Securities and Exchange Act of 1934.

Now that the dust has settled, we can start to analyze what all this means for the digital asset industry. Upon review, the Bitcoin rally might have been the more impactful event.

On April 3, a statement entitled “Framework for ‘Investment Contract’ Analysis of Digital Assets” (the “Framework”) was issued by Bill Hinman, Director of Division of Corporation Finance, and Valerie Szczepanik, Senior Advisor for Digital Assets and Innovation; and the Commission’s Division of Corporation Finance issued its first no-action letter regarding digital assets to TurnKey Jet, Inc., a U.S.-based air carrier and air taxi service.

The Framework goes out of its way to caution that it represents the views of the Strategic HUB for Innovation and Financial Technology of the Commission and is not a rule, regulation or statement of the Commission: that the Commission has neither approved nor disapproved its content; and that it is not binding on the Divisions of the Commission. The Framework further emphasizes its limited scope: “Even if no registration is required, activities involving digital assets that are securities may still be subject to the Commission’s regulation and oversight,” for example buying, selling, or trading; facilitating exchanges; and holding or storing digital assets. Thus, the Framework has limited utility from a factual, legal or precedential standpoint. Nevertheless, we expect it to be a significant source document that will be cited by the Commission, practitioners, and courts alike.

On the same day, the Commission’s Division of Corporation Finance issued its first no-action letter regarding digital assets to TurnKey Jet, Inc., a U.S.-based air carrier and air taxi service (the “No-Action Letter”). The No-Action Letter is not binding on the Commission and only applies to the very specific, and restrictive, set of conditions presented in the No-Action Letter request and, therefore, it does not have broad implications for the industry in general. Like the Framework, the No-Action Letter provides little guidance to the industry, but it should be touted as a step in the right direction, albeit a small step.

Though the Framework and No-Action Letter are not as helpful as some might have hoped, both are key developments that shed light on the Staff’s current views regarding the regulation of digital assets and the activities of industry participants under the federal securities laws.

The Framework

The Framework, which the Staff emphasized does not “replace or supersede existing case law, legal requirements or statements or guidance” from the SEC, largely relies on the 73-year-old Howey test for determining whether a digital asset is a security in the form of an “investment contract.” The Howey test is composed of four prongs: (i) an investment of money; (ii) in a common enterprise; (iii) with a reasonable expectation of profit; (iv) derived from the efforts of others.

The Framework succinctly analyzes the applicability of the first two prongs to an offer and sale of a digital asset in three sentences and reserves the other nine pages for the latter two prongs. It is reasonable to ask whether the existence of a common enterprise in an offer and sale of a digital asset is as foregone a conclusion as the SEC evidently believes.

The Framework introduces a term to identify the principal actor or actors in the development or maintenance of a digital asset network, an “Active Participant” or “AP,” broadly defined to include a “promoter, sponsor, or other third party (or affiliated group of third parties).” The activities of the Active Participants are emphasized as critical factors for determining whether a purchaser has a reasonable expectation of profits (or other financial return) to be derived from the efforts of others. This is an expansive reading of the Howey test. For example, under the Framework the following are indicative of reliance by the purchaser of a digital asset on the “efforts of others”: (i) when an AP promises “further developmental efforts in order for the digital asset to attain or grow in value”; (ii) when the purchaser expects that the AP will be “performing or overseeing tasks that are necessary for the network or digital asset to achieve or retain its intended purpose or functionality”; (iii) an AP creates or supports a market for the digital asset; (iv) an AP maintains a managerial role in the project; and (v) when a purchaser would reasonably expect the AP to “undertake efforts to promote its own interests and enhance the value of the network or digital asset.” As an aside, introducing the concept of “Active Participant” suggests that the SEC might be in the early stages of promulgating a refined regulatory scheme for digital currency that focuses on the role of actors whose efforts help maintain or enhance the value of existing currency.

In the section entitled “Other Relevant Considerations,” the Framework spells out how a digital asset can be structured to avoid being considered a security. As a general matter, the stronger the presence of certain identified characteristics, the less likely a digital asset would constitute a security under the Howey test. These characteristics include (i) the network is fully developed and operational; (ii) holders of the digital asset are immediately able to use it for its intended functionality; (iii) the good or service underlying the digital asset can only be acquired, or more efficiently acquired, through the use of the digital asset on the network; and (iv) the digital asset is marketed in a manner that emphasizes the functionality of the digital asset. However, some of the other characteristics cited would pose challenges for “traditional” digital asset issuances, including: (i) prospects for appreciation in the value of the digital asset are limited, e.g. the design of the digital asset provides that its value will remain constant or even degrade over time; and (ii) if the AP facilitates the creation of a secondary market, transfer of the digital asset may be made only by and among users of the platform.

The Framework briefly discusses when a digital asset “previously sold as a security” should be reevaluated at the time of later offer or sale. Relevant considerations in that reevaluation include whether purchasers “no longer reasonably expect that continued development efforts of an AP will be a key factor for determining the value of the digital asset.” The broad definition of AP is especially troubling when coupled with the Framework’s broad list of examples of continued involvement by the AP in the development or management of the network or digital asset because it arguably could apply to almost any project in the industry.

This discussion is largely a restatement of Director Hinman’s oft-cited speech “When Howey Met Gary (Plastic),” and is generally not helpful in addressing the great leap required to transition from a product developed by a group of identifiable individuals to a “de-centralized” organization. Note that the Framework does not address, among other things, the status of SAFTs and the issuance of tokens thereunder. It also says nothing about projects where sale of tokens are restricted to non-U.S. buyers, and U.S. residents later wish to use the tokens.

No-Action Letter

In the No-Action Letter, the Division of Corporation Finance indicated that, subject to specified conditions, it would not recommend enforcement action to the Commission if TurnKey Jet offers and sells its tokens without registration under the Securities Act and the Exchange Act. The No-Action Letter is instructive because it provides an example of the narrow range of activities that, under the Framework, would exclude a digital currency from treatment as a security. Some of the key features of the digital asset represented in the No-Action Letter request include:

  • TurnKey will not use any funds from the token sale to develop its platform, network, or application, and “[e]ach of these will be fully developed and operational at the time any tokens are sold.”
  • TurnKey’s tokens will be immediately usable for their intended functionality when they are sold.
  • The seller must restrict transfers of the tokens to its proprietary wallet.
  • The token’s marketing focuses on the functionality of the token and not its investment value.
  • The tokens will be priced at US$1 per token “through the life of the program” with each token essentially functioning as a prepaid coupon for TurnKey’s air charter services.

While TurnKey can celebrate being the recipient of the first no-action letter regarding the registration requirements of the Securities Act and the Exchange Act applicable to digital assets, the highly restrictive covenants it must abide by to avoid registration are in conflict with the characteristics of most ICOs and, therefore, the No-Action Letter provides little relief to the typical industry participant.


Although the Framework and the No-Action Letter largely reiterated what digital asset market participants already knew, taken together they have opened the door to further constructive discussions with the Staff that, hopefully, will produce more clear-cut guidance based upon the analysis of specific cases.

The Beat Goes On: Division of Investment Management Seeks Input on the Impact of the Custody Rule on Digital Currency – and Vice Versa

As part of its ongoing examination of the Custody Rule, the SEC’s Division of Investment Management is seeking views from the securities industry members and the public on two issues regarding the Custody Rule: (1) the application of that rule to trading that is not handled on a delivery versus payment basis, and (2) the application of the rule to digital assets. In a March 12, 2019 letter to the President and CEO of the Investment Adviser Association published on the SEC’s website (“the Custody Release”), the Division seeks input to expand on its Guidance Update from early 2017. Both issues are important in view of the increasing complexity of types of securities that registered investment advisers are purchasing on behalf of their customers and, as discussed below, the issues overlap in a way that might predict an important use case for blockchain technology.

The Custody Rule

The Custody Rule under the Investment Advisers Act of 1940 provides that it is a fraudulent, deceptive or manipulative act, practice or course of business for a registered investment adviser to have “custody” of client funds or securities unless they are maintained in accordance with the requirements of the Custody Rule. The definition of custody includes arrangements where the adviser has authority over and access to client securities and funds.

By way of context, we note that although the Custody Rule applies only to registered investment advisers, its concepts are relevant for non-registered advisers and other intermediaries as well, since their clients or customers have a practical interest in assuring that: managed assets are appropriately safeguarded; and the absence of appropriate custody arrangements may preclude a client from investing with a particular adviser.

Also, as the Custody Release notes, the Division previously issued a letter inviting engagement on questions relating to the application of the Investment Company Act of 1940, including the custody provisions of that Act, to cryptocurrencies and related products.

The Custody Rule and DVP Arrangements

The Custody Release points out that when an investment adviser manages funds pursuant to delivery versus payment arrangements – that is, when transfers of funds or securities can only be conducted together with a corresponding transfer of securities or funds – then it provides certain protections to customers from misappropriation by the adviser. The Release seeks to assist the Division in gathering information on payment practices that do not involve delivery versus payment, seeking input on, among other things: the variety of instruments that trade on that basis; the risk of misappropriation or loss associated with such trading; and how such trades appear on client accounts statements.

The Custody Rule and Digital Assets

The Custody Release also asks about the extent to which evolving technologies, such as blockchain/distributed ledger technology, provide enhanced client protection in the context of non-delivery versus payment trading. That question presents a good lead-in to the second part of the Custody Release, which seeks to learn “whether and how characteristics particular to digital assets affect compliance with the Custody Rule.” These characteristics include:

– the use of distributed ledger technology to record ownership;

– the use of public and private cryptographic keys to transfer digital assets;

– the “immutability” of blockchains;

– the inability to restore or recover digital assets once lost;

– the generally anonymous nature of DLT transactions; and

– the challenges posed to auditors in examining DLT and digital assets.

With these characteristics in mind, the Division asks are fairly open-ended about the challenges faced by investment advisers in complying with the Custody Rule with respect to digital assets, including:

– to what extent are investment advisers construing digital assets as funds or securities?

– are investment advisers including digital assets in calculating regulatory assets under management in considering with they need to register with the SEC?

– how can concerns about misappropriation of digital assets be addressed?

– what is the process for settlement of digital asset transactions, either with or without an intermediary?

The most forward-looking question asked in the Release is whether digital ledger technology can be used for evidencing ownership of securities. The answer to this question – which could represent a direct application of the blockchain’s ability to record ownership and its immutability – could pave the way to resolving custody concerns with respect to any asset class transacted in by investment advisers on behalf of their clients. It certainly points the way to an important possible use of blockchain technology – to demonstrate custody in a way that is immutable, anonymous and auditable. Technologists, get to work!

The Custody Release’s questions are a significant next step in drawing digital assets into the embrace of investment adviser regulation, but a positive step nonetheless.

Blockvest II: Court Reverses Itself and Grants the SEC a Preliminary Injunction in the Face of Manifest Fraud

As we previously discussed, the SEC suffered a rare defeat in Securities and Exchange Commission v. Blockvest, LLC et al. on November 27, when Judge Curiel of the U.S. District Court for the Southern District of California issued a denial (the “November Order”) of its motion for a preliminary injunction against Defendants’ future violations of Section 17(a) of the Securities Act of 1933 (“Section 17(a)”), despite manifest evidence of fraudulent representations in the Defendants’ website postings. The November Order attracted intense scrutiny and on December 17, the SEC moved for partial reconsideration of the November Order. Last week, on February 14, the court granted, in part, the SEC’s motion for reconsideration (the “February Order” and, together with the November Order, the “Orders”), relying on purported new evidence and an argument that the court apparently had overlooked. It is fair to ask whether the new evidence motivated the reversal.

As Judge Curiel recited, under the Federal Rules of Civil Procedure, a motion for reconsideration is appropriate, among other reasons, if the district court is “presented with newly discovered evidence.” Judge Curiel stated that the standard for granting a preliminary injunction requires the SEC to show: “(1) a prima facie case of previous violations of federal securities laws, and (2) a reasonable likelihood that the wrong will be repeated.” Based upon these standards, the court concluded that reconsideration in this case was warranted “based upon a prima facie showing of Defendants’ past securities violation and newly developed evidence which support the conclusion that there is a reasonable likelihood of future violations.” However, it is not clear what “newly developed evidence” formed the basis for this conclusion.

In applying the Howey test to the tokens offered by Blockvest, the court agreed with the SEC that “the Howey test is unquestionably an objective one.” The court disputed the SEC’s assertion that in the November Order the court had applied a “subjective test” by relying solely on the beliefs of some individual investors. Rather, the court stated that it had “objectively inquire[d] into the ‘terms of promotional materials, information, economic inducements or oral representations at the seminars, or in other words, an inquiry into the ‘character of the instrument or transaction offered’ to the ‘purchasers.’”

The court emphasized that in the November Order it had denied the motion for a preliminary injunction “because there were disputed factual issues as to the nature of the investment offered to alleged investors.” Nonetheless, the court acknowledged that in denying the SEC’s motion for a preliminary injunction, it did not “directly address” an alternate theory originally presented by the SEC that the promotional materials presented on Defendants’ website, in the whitepaper posted online, and on social media accounts concerning the ICO of the token constituted an offer of unregistered securities that contained materially false statements and therefore violated Section 17(a). The court again applied the Howey test to find that the tokens being offered were securities. The court also rejected the defendants’ arguments that applied state law to interpret “offer” narrowly to require a manifestation of an intent to be bound, finding that “offer” is broadly defined under the securities laws.

The court also found that the SEC had satisfied the required showing that there is a reasonable likelihood of future violations, one of the elements of injunctive relief. In support of its ruling, the court cited the misrepresentations in Defendants’ website postings that had been detailed in the November Order and which were manifestly fraudulent. Based upon this information, addressed by the SEC in supplemental briefing, the court granted partial reconsideration of the November Order.

Also factored into the February Order were the findings that defense counsel had moved to withdraw as counsel because “the firm found it necessary to terminate representation due to, inter alia, Defendants instructing counsel to file certain documents that counsel could not certify under Rules of Civil Procedures 11… and Defendants have yet to find substitute counsel.” The court stated its concerns that Defendants would resume their prior alleged fraudulent conduct, in light of its order allowing defense counsel to withdraw.

Given the severity of the fraudulent representations as alleged in the SEC’s action, which included false claims of approval by federal regulators and a wholly fabricated federal agency, it was surprising that the court had originally denied the SEC’s request for a preliminary injunction; the need to shut down ongoing fraud and protect investors often drives a court’s rulings on requests for interim relief in these cases. It appears that in reversing itself, the court rethought its reasoning based on the information and arguments that the SEC had originally presented. In one telling ruling in the new decision, the court declined to accept new arguments raised by defendants in opposition to the motion for reconsideration because they had not previously raised them. It appears that the SEC can shrug off its original loss and continue to seek to shut down this alleged fraud with all the power of the federal securities laws.

SEC and FINRA Confirm Digital Assets a 2019 Examination Priority

Recently, the Staffs of the SEC and FINRA announced their annual examination and regulatory priorities: the SEC’s Office of Compliance, Inspections and Examinations (OCIE) issued its 2019 Examination Priorities just before its employees were sent home on furlough, and FINRA issued its 2019 Risk Monitoring and Examination Priorities Letter last week, several weeks later than its usual first-of-the-year release. The high points and overlap of the two releases are covered in an Orrick Client Alert, but for purposes of On the Chain, we will briefly discuss the two regulators’ not-surprising designation of digital currency as one of their priorities.

The priorities letters clearly telegraph both regulators’ intentions to examine firms’ participation in the digital assets marketplace. OCIE flags digital assets as a concern because of the market’s significant growth and risks. OCIE indicates that it will issue high-level inquiries designed first to identify market participants offering, selling, trading, and managing these assets, or considering or actively seeking to offer these products. Once it identifies those participants, OCIE will then assess the extent of their activities and examine firms focused on “portfolio management of digital assets, trading, safety of client funds and assets, pricing of client portfolios, compliance, and internal controls.”

For its part, FINRA treats digital assets under the heading of “Operational Risks,” and encourages firms to notify it if they plan to engage in activities related to digital assets, even, curiously, “where a membership application is not required.” In this context, FINRA references its Regulation Notice 18-20, July 6, 2018, which is headlined “FINRA Encourages Firms to Notify FIRNA If They Engage in Activities Related to Digital Assets.” These initiatives provide a partial explanation for the long-expected delays in FINRA granting member firms explicit authority to effect transactions in digital assets.

FINRA also states its intention to review these activities and assess firms’ compliance with applicable securities laws and regulations and related supervisory, compliance and operational controls to mitigate the risks associated with such activities. FINRA states that it will look at whether firms have implemented adequate controls and supervision over compliance with rules related to the marketing, sale, execution, control, clearance, recordkeeping and valuation of digital assets, as well as AML/Bank Secrecy Act rules and regulations. These issues are addressed in detail in FINRA’s January 2017 report on “Distributed Ledger Technology: Implications of Blockchain for the Securities Industry.”

The SEC and FINRA clearly will seek to align their concerns about firms participating in the digital asset markets and the compliance and supervision standards to which they will hold them. The regulators’ jurisdiction overlaps, but the SEC’s is broader – it extends to all issuers, while FINRA would be limited only to those issuers that are member broker-dealer firms. The SEC also has jurisdiction over investment advisers, while FINRA again is limited to those advisers who are members. And because the SEC effectively owns the definition of security, FINRA also states its intention to coordinate closely with the SEC in considering how firms determine whether a particular digital asset is a security. At the same time, FINRA has jurisdiction over any activities engaged in by broker-dealers with respect to its customers, even those that do not involve a security, meaning that a member firm’s transactions in or custody of, for example, bitcoin – declared by the SEC not to be a security – still will implicate FINRA’s oversight.

The regulators’ coordination on their digital currency reviews will likely not diminish regulatory attention, but at least it will provide industry participants some comfort that coordinated thought is being given to how best to regulate this emerging area.

A Foreboding View of Smart Contract Developer Liability

At least one regulator is attempting to provide clarity regarding the potential liability of actors who violate regulations through the use of smart contracts. On October 16, 2018, Commissioner Brian Quintenz of the Commodity Futures Trading Commission explained his belief that smart contract developers can be held liable for aiding and abetting CFTC rule violations if it was reasonably foreseeable that U.S. persons could use the smart contract they created to violate CFTC rules. As is typical, the Commissioner spoke for himself, but it seems likely that his views reflect the CFTC’s philosophy.

Generally speaking, smart contracts are code-based, self-executing contractual provisions. Smart contracts that run on top of blockchain protocols, like ethereum, are increasingly being used by companies in a wide variety of businesses to create autonomous, decentralized applications. Some of these applications might run afoul of CFTC regulations if they have the features of swaps, futures, options, or other CFTC-regulated products, but do not comply with the requisite regulatory requirements. The fact that smart contracts support disintermediated markets – a departure from the market intermediaries traditionally regulated by the CFTC – does not change the CFTC’s ability to extend its jurisdiction to them.

To identify where culpability might lie, Commissioner Quintenz identified the parties he believes to be essential to the functioning of the smart contract blockchain ecosystem:

  1. the core developers of the blockchain software;
  2. the miners that validate transactions;
  3. the developers of the smart contract applications; and
  4. users of the smart contracts.

Commissioner Quintenz dismissed the core developers and the miners as potential culpable parties by reasoning that while they both play a vital role in creating or administering the underlying blockchain code, they have no involvement in creating the smart contracts. He also limited the possibility of the CFTC pursuing enforcement against individual users because, as he explained, although individual users are culpable for their actions, “going after users may be an unsatisfactory, ineffective course of action.”

That leaves the developers of the smart contract code. Commissioner Quintenz stated that to ascertain the culpability of the smart contract code developers, the “appropriate question is whether these code developers could reasonably foresee, at the time they created the code, that it would likely be used by U.S. persons in a manner violative of CFTC regulations.” If such a use is foreseeable, Commissioner Quintenz believes that a “strong case could be made that the code developers aided and abetted violations of CFTC regulations.”

Commissioner Quintenz expressed that he would much rather pursue engagement than enforcement, “but in the absence of engagement, enforcement is the only option.” The Commissioner recommended that smart contract developers engage and collaborate with the CFTC prior to releasing their code to ensure that the code will be compliant with the law. The Commissioner even suggested that the CFTC is willing to rethink its existing regulations or provide regulatory relief, depending on the technology in question.

As blockchain and smart contract technology matures, we expect decentralized and disintermediated applications to come to market in increasing volumes. In his speech, Commissioner Quintenz provided valuable insight into how one regulator is thinking about applying existing laws to this new market. His remarks will be especially valuable if they influence other regulators, such as the Securities and Exchange Commission or the Financial Crimes Enforcement Network, to take a similar approach.