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

A “Key” OCC Interpretation – National Banks Can Provide Cryptocurrency Custody Services

Banking regulators took a significant step toward the mainstreaming of cryptocurrency recently when the Office of the Comptroller of the Currency (OCC) provided guidance about how a bank can provide custody services for cryptocurrency. In Interpretive Letter #1170, published on July 22, the OCC concludes that “a national bank may provide these cryptocurrency custody services on behalf of customers, including by holding the unique cryptographic keys associated with cryptocurrency.”

The OCC’s Letter arrives at an opportune time, when, according to CipherTrace’s recently published findings, the majority of cryptocurrency transactions are cross-border and, on average, each of the top ten U.S. retail banks unknowingly processes an average of $2 billion in crypto-related transactions per year. Providing custody services might help bring more of these transactions in to the open.

The OCC Interpretive Letter

The Interpretive Letter—which was issued just a few short months after the former Coinbase chief legal officer Brian Brooks became the Acting Comptroller of the Currency—is a breakthrough in terms of bringing cryptocurrency within a regulated environment. The OCC outlined three sources of market demand for banks to provide cryptocurrency custody services: (1) cryptocurrency owners who hold private keys want to store them securely because private keys are irreplaceable if lost—misplacement can mean the loss of a significant amount of value; (2) banks may offer more secure storage services than existing options; and (3) investment advisors may wish to manage cryptocurrencies on behalf of customers and use national banks as custodians.

The OCC recognized that, as the financial markets become increasingly technological, there will likely be increasing need for banks and other service providers to leverage new technology and innovative ways to provide traditional services on behalf of customers. The OCC pointed out that cryptocurrency custody services fit neatly into the long-authorized safekeeping and custody services national banks provide for both physical and digital assets.

With respect to cryptocurrency, the Letter states that national banks may provide fiduciary and non-fiduciary custody services. Non-fiduciary custodial services typically entail providing safekeeping services for electronic keys, which, as discussed above, fit neatly into the types of activities national banks have historically performed. Specifically, the OCC explains that a bank that provides custody for cryptocurrency in a non-fiduciary capacity typically would not involve physical possession of the cryptocurrency but rather “essentially provide safekeeping for the cryptographic key that allows for control and transfer of the customer’s cryptocurrency.” Fiduciary cryptocurrency custody services (such as those where the service provider acts as trustee, administrator, transfer agent, or receiver, or receives a fee for providing investment advice) are permissible if conducted in compliance with the National Bank Act and other applicable laws and regulations (such as 12 CFR Part 9 and 12 U.S.C. Ch. 2). Banks are authorized to manage cryptocurrency assets in a fiduciary capacity just as they manage other types of assets in a fiduciary capacity.

Banks that provide cryptocurrency custody services have to comply with existing policies, laws, and regulations, and conduct its custody services in a safe and sound manner, including having adequate systems in place to identify, measure, monitor, and control the risks of its custody services. In particular, banks should ensure they assess the anti-money laundering (AML) risk of any cryptocurrency custodial services and update their AML programs to address that risk. It would be advisable for AML compliance personnel to be well-integrated in the development of cryptocurrency custodial services. Banks must also implement effective risk management programs and legal and regulatory reporting practices for these services. Cryptocurrency custody services may raise unique issues identified by the OCC, including the treatment of blockchain forks, and consideration of whether technical differences between cryptocurrencies (for example, those backed by commodities, those backed by fiat, or those designed to execute smart contracts) may require different risk management practices.

The OCC Letter points out that different cryptocurrencies may be subject to different regulations and guidance. For example, some cryptocurrencies are deemed securities and therefore are subject to federal securities laws and regulations. In addition, because crypto assets are thought of as offering a greater level of anonymity or as falling beyond the ken of centralized banking systems, they have been associated with illicit activity including money laundering. Consequently, banks must ensure that their AML programs are appropriately tailored to effectively assess customer risk and monitor crypto-related transactions. Just yesterday, the Financial Crimes Enforcement Network published an advisory warning that “[f]inancial institutions dealing in [cryptocurrency] should be especially alert to the potential use of their institutions to launder proceeds affiliated with cybercrime, illicit darknet marketplace activity, and other [cryptocurrency]-related schemes and take appropriate risk mitigating steps consistent with their BSA obligations.”

While there has been limited enforcement of federal law against banks for crypto-currency related activity, earlier this year, the OCC brought its first crypto-related enforcement action, against M.Y. Safra Bank for deficient AML processes for digital asset customers. The OCC concluded that the Bank’s deficiencies included its failure to: (1) appropriately assess and monitor customer activity flowing to or from high-risk jurisdictions; (2) conduct ongoing testing of its due diligence processes; (3) implement sufficient controls for its digital assets customers, including cryptocurrency money service businesses (MSBs); (4) address the risk created by the significant increase in wire and clearing transactions created by the cryptocurrency MSB customers; and (5) notify the OCC of its significant deviation from its previous business plan. In the Matter of M.Y. Safra Bank, SFB, AA-NE-2020-5, Consent Order (Jan. 30, 2020).

The OCC’s Letter should give comfort to many banks that have been bystanders to the growth of the cryptocurrency market. Now banks can offer more cryptocurrency-based financial services with more certainty, although many questions will likely be answered through greater participation. More marketplace involvement by traditional banks will in turn have a beneficial effect. Smaller businesses wishing to engage in cryptocurrency-based transactions now may do so by interacting with large, stable, and well-regulated banking institutions.

OCC’s Consideration of an MSB Regime

OCC’s Interpretive Letter may be part of a broader movement by the OCC to promote greater integration of cryptocurrencies into mainstream financial services. Acting Comptroller of the Currency Brooks announced on a podcast on June 25 that the OCC intends to unveil a new bank charter including a national payments charter that will pave the way for nationwide participation by cryptocurrency payments companies. As contemplated, that charter would be equivalent to FinCEN’s MSB registration process and stand in (under the doctrine of preemption) for individual state-level MSB licensing requirements. It also should answer questions like how the Community Reinvestment Act might apply to banks that do not take deposits and how the OCC will impose capital standards on companies that do not bear credit risk.

New York Looks Like it Might Loosen Up on Its Virtual Currency Regulation

On June 25, the New York State Department of Financial Services (NYDFS) published a “Conditional BitLicense” proposal for reforming its licensing framework that would make it easier for virtual currency businesses to obtain permission to operate in New York. The proposal was developed as part of a broader effort to respond to industry changes and concerns that NYDFS identified in its five-year review of its cryptocurrency licensing regime (which originally took effect in June 2015) under which more than two dozen cryptocurrency companies have been approved to do business in New York. Under the proposed regulations, a virtual currency firm will be authorized to operate in New York even if it does not have a full BitLicense from the state if it obtains a “conditional BitLicense” and partners with a firm that does have a full license. (To note, the conditional BitLicense has always existed, but this is the first time that the NYDFS has announced clear rules to help companies access the license.)

The NYDFS’s proposal is likely a welcome development. New York’s process for obtaining a full BitLicense is considered one of the toughest in the country and has long been unpopular with blockchain startups. Among the complaints: steep paperwork requirements and lengthy approval times. Under the proposed conditional licensing regulation, a cryptocurrency firm that wishes to operate in New York can bypass the difficulties of applying for a full license and instead apply for a conditional BitLicense, which would grant it operational privileges so long as it partners with another cryptocurrency firm that is fully licensed. Currently, the NYDFS envisions that under such a partnership, the licensed firm can assist in providing various services and support, including “those relating to structure, capital, systems, personnel, or any other support needed.”

The proposed application process is simple: In order to apply for such a license, the unlicensed cryptocurrency firm would need to inform the NYDFS of its intention to apply and provide a copy of the service agreement between the unlicensed cryptocurrency firm and the licensed cryptocurrency firm, as well as additional documentation. It is clear, however, that the NYDFS views this licensing framework as a temporary stepping stone; the NYDFS stated that it expects firms who obtain such conditional licenses to then apply for a full license within 2 years.

It is not entirely clear how the conditional license will operate in practice. It does not appear that any other state makes conditional licenses available. To that end, the NYDFS is inviting comments on its proposed regulation, including:

  1. What type of cryptocurrency firms would benefit the most from such a conditional license?
  2. What type of licensed firms would be best and most effectively able to partner with unlicensed firms under the terms of a conditional license?
  3. What types of services and support should a licensed firm provide for the firm with the conditional license?
  4. Should there be limits placed on the types of services that a licensed firm can provide?
  5. Should there be caps and limits on the total number of conditional arrangements that a licensed firm can enter? What other checks should be in place?
  6. Should the licensed firm be held accountable for initial due diligence of the firm wishing to obtain a conditional license and to what extent?
  7. Should ongoing due diligence be required?
  8. How should the licensed firm and firm with the conditional license divide responsibilities and obligations for ensuring compliance with legal and regulatory requirements?
  9. What is the best way to check for and resolve conflicts of interest between the two firms involved?
  10. What is the best way to structure such collaboration to limit any potential adverse effect on the markets?
  11. Are there other methods besides a conditional license that the NYDFS should consider?

NYDFS requests that all comments by submitted by August 10, 2020. Given that cryptocurrency regulation is generally uncharted territory, virtual currency firms should consider submitting comment to the NYDFS to assist it in developing this regulation further so that it is effective and workable.

In or Out? – The CFTC Explains When Virtual Currencies Come Within Its Jurisdiction

On March 24, the Commodity Futures Trading Commission (CFTC) issued final interpretive guidance (the Guidance) regarding retail commodity transactions involving virtual currency. In short, this Guidance clarifies when “actual delivery” of virtual currency (such as bitcoin and ether) occurs under the test determining whether a leveraged arrangement is exempt from regulation by the CFTC as, effectively, a futures contract. This important Guidance demonstrates the proactive and leading role that the CFTC has taken in connection with understanding and addressing developments in the fintech sector. In the Guidance, the CFTC explains the exemption clearly and places it in the context of the CFTC’s regulatory mandate, its somewhat tortured history in obtaining jurisdiction over leveraged retail transactions in commodities, and its interest in preventing abusive practices. As part of its commitment to assisting the industry in adjusting to the evolving interpretations, the CFTC also announced that it would impose a 90-day moratorium on initiating enforcement actions that address aspects of the Guidance that, according to Chairman Tarbert’s accompanying statement, “were not plainly evident from prior CFTC guidance, enforcement actions, and case law.”

The Guidance in effect enables those transacting in leveraged virtual currency (often referred to as “cryptocurrency”) to understand whether they are subject to CFTC jurisdiction. As noted in the release, the CFTC has exclusive jurisdiction over commodity futures, options and swaps – which encompasses a broad range of derivatives – and has broad anti-fraud and anti-manipulation authority over any contract of sale of any commodity in interstate commerce, as well as swaps and futures. This jurisdiction includes certain speculative commodity transactions involving leverage or margin, which are also treated by the CFTC as futures. The CFTC’s jurisdiction over leveraged retail transactions remained uncertain until passage of the Dodd-Frank Act in 2010.

Before the Dodd-Frank Act, it was possible that a retail transaction in a commodity entered on a leveraged or margined basis, or financed by the counterparty, could avoid regulation by the CFTC even though it was economically indistinguishable from a futures contract. In his statement, Chairman Tarbert offers this example: suppose that someone decides to purchase a commodity with some money down, with delivery and final payment to be made at some future date, but is also able to trade out of the position at any time to lock in any gains or losses incurred to date; “that starts to look an awful lot like a futures contract—with identical economics but without any regulation.” The Dodd-Frank Act addressed this regulatory gap, with a particular application to abusive sales practices involving foreign currency and precious metals, and now the Guidance provides interpretation to apply the same principles to virtual currency.

The important exception to the CFTC’s jurisdiction over leveraged retail commodity transactions is for a contract of sale that “results in actual delivery within 28 days…” The determinative factor as to whether a transaction in virtual currency is subject to CFTC jurisdiction is whether actual delivery occurs within 28 days of trade execution. (Note that, for retail foreign currency transactions, the delivery period is only two days.) In its 2015 Coinflip Order, the CFTC clarified that virtual currency constitutes a “commodity” under the Commodity Exchange Act. Although virtual currency is an intangible commodity, the CFTC has jurisdiction over other types of intangible commodities, including rate indices and renewable energy credits. Multiple federal courts have also held that virtual currencies are commodities under the Commodity Exchange Act. The CFTC broadly defines virtual currencies as follows:

a digital asset that encompasses any digital representation of value or unit of account that is or can be used as a form of currency (i.e., transferred from one party to another as a medium of exchange); may be manifested through units, tokens, or coins, among other things; and may be distributed by way of digital “smart contracts,” among other structures.

In the Guidance, the Commission interprets “actual delivery” in the context of virtual currency as taking place when (a) a customer (i) secures possession and control of the entire quantity of the commodity – whether it was purchased on margin, or using leverage, or any other financing arrangement – and (ii) has ability to use the entire quantity of the commodity freely in commerce, no later than 28 days from the date of the transaction; and (b) the offeror and counterparty seller do not retain any interest in, legal right, or control over any of the purchased commodity after 28 days from the date of the transaction. While this interpretation is carefully drafted to avoid permitting any “sham delivery” to qualify, the Guidance states that the simplest definition of actual delivery is the ability of a purchaser to use the virtual currency immediately as a unit of exchange. And while the 28-day period is provided as the outside time limit to constitute actual delivery, as a practical matter, it typically takes much fewer than 28 days for a virtual currency transfer to complete. To determine whether the seller no longer retains any interest in the virtual currency, the CFTC may look to whether the seller retains any ability to access or withdraw any quantity of the virtual currency from the purchaser’s account or virtual wallet. The Guidance essentially reaffirms guidance that the CFTC provided in 2013, in a non-virtual currency context, as to the “functional approach” that the CFTC would apply in determining whether actual delivery had occurred.

In the Guidance, the CFTC emphasizes the importance of virtual currencies and their underlying blockchain technologies, and highlights its efforts to take a “deliberative and measured approach” in this area, to avoid stifling technological innovation. The CFTC points to its efforts in this area, including the LabCFTC initiative, which seeks to promote market-enhancing innovation. It also notes that several derivatives contracts based on virtual currency are listed on CFTC registered entities. The Guidance also reports that the CFTC continues to follow the evolution of the cash market for virtual currencies, since cash markets affect related derivatives markets. It is because the technology, market structures and law are evolving so quickly that, as discussed by several Commissioners in their accompanying statements, issuing interpretive guidance is more appropriate than rulemaking at this time. We encourage readers to refer to the CFTC’s full Guidance, which is clearly written with helpful examples.

At Your Service: First-Ever On the Chain Survey Reflects a Steady Rise in Blockchain Awareness, Acceptance and Adoption

The results are in! Responses to Orrick’s first survey of the dedicated followers of On the Chain, our blockchain blog, revealed at least two things: (1) that blockchain technology is continuing to gain acceptance in and figure into plans of businesses across numerous industries, and (2) that during the holiday season people will take the time to respond to a survey if there is a prospect of receiving an Amazon gift card. Message received.

The 60+ survey responses came largely from senior personnel in a broad range of industries and regions, mostly working in technology, media, telecommunications, professional services, fintech and financial services, and mostly located in North America, Asia and Europe. Overall, almost all responders considered themselves moderately or very familiar with blockchain technology, which is not surprising given the nature of the blog’s steadily increasing readership. It is also not surprising, since one-third of the responders stated they work for companies that currently employ blockchain technology, including smart contracts. These uses include: payment processing and investments; buying, selling and exchanging digital currencies; data management and storage; maintaining data privacy; and gaming. For those companies not currently employing blockchain technology, about a third view it as a high priority or important to the organization; and about one-half of those view it as relevant to the company’s strategy but not a priority.

The overwhelming majority of responders believe that blockchain will achieve mainstream adoption in the next five years. This matches the observation of Orrick’s Blockchain Group, whose members from week to week seem to be working on or learning about a new or expanded application of blockchain technology in an existing industry. The greatest advantage to the adoption of blockchain technology, according to responders, is improved business efficiencies, while reduction of costs is viewed as a lesser benefit. The most significant barriers to mainstream adoption of blockchain technology are considered to be technological challenges to implementation, regulatory issues and the uncertain financial return on the investment. We received fewer responses that security threats, failure of companies to treat it as a priority, and unproven technology are barriers to adoption.

In sum, the survey results provide a snapshot – albeit unscientific – of how companies view blockchain technology at this point in time, and where they think it is going. The results help Orrick to focus its blockchain practice on the sectors where our advice and representation will most likely be useful. And, lastly, the results help us deliver our observations and analyses about “the state of blockchain” to our clients and other members of our audience. Survey responders expressed a preference for hearing from us through our electronic newsletter and our On the Chain blog, and we will continue to deliver content in those forms. Many responders also indicated that they would appreciate reading posts regarding success stories and practical uses of blockchain technology. We intend to start publishing regular pieces, so stay tuned for that. And many responders also sought human interaction with the charming and knowledgeable members of Orrick’s Blockchain Group – seminars and networking receptions – and we hope to announce such opportunities in the near future. Finally, we are grateful to those responders who provided ideas about the content for future blog posts (and those who appreciate the topics we have already offered). Look for content that is responsive to those requests.

Thanks again to all our survey respondents for taking the time to provide such useful information, and congratulations to our lucky prizewinner!

They Did It for the Gram: SEC and Telegram File Dueling Expert Reports

The battle in federal court between the SEC and Telegram continues to progress at breakneck speed. The SEC commenced its action less than four months ago, on October 11, 2019, by seeking a temporary restraining order against Telegram Group Inc. and TON Issuer Inc. (collectively, “Telegram”). That same day, Judge Castel in the Southern District of New York granted the SEC’s TRO request and ordered expedited discovery. Months of intensive discovery ensued that culminated with both parties filing cross motions for summary judgment on January 15, 2020.

At the center of the dispute is whether issuers of digital tokens can avoid registering their sale with the SEC by issuing them pursuant to “SAFTs,” or Simple Agreements for Future Delivery. SAFTs are commercial instruments used to convey rights to digital tokens to sophisticated investors prior to the development of the functionality of the platform on which the tokens are designed to operate. Issuers usually treat SAFTs as securities and offer and sell them pursuant to the exemption from registration in Rule 506(c) of Regulation D under the Securities Act of 1933. The digital tokens are later issued pursuant to the SAFTs once the platform for which the tokens were designed to use is “fully functional.” The theory is that once use-cases exist for the tokens, they no longer constitute securities, but rather utility tokens that can be distributed as commodities or currency without being subject to regulation as securities by the SEC. The SEC action against Telegram based upon its SAFTs and intended issuance of Grams is the first litigated case to contest that theory.

According to the SEC, from January 2018 to March 2018 Telegram entered into SAFTs with sophisticated investors for the future delivery of Grams. Grams have not yet been delivered. In its TRO motion, the SEC argued that the Grams were securities at the time the SAFTs were executed and the temporal separation between the signing of the SAFTs and delivery of the Grams upon the launch of the fully functional Telegram platform (the “TON Blockchain”) is immaterial and does not change the nature of the Grams themselves. The SEC further argued that upon delivery of the Grams to the SAFT investors, those investors will be able to resell the Grams without restrictions. “Once these resales occur, Telegram will have completed its unregistered offering” for which no exemption from registration exists.

In opposition, Telegram argued that the Grams must be separately analyzed from the SAFTs under the federal securities laws. Telegram contended that the Grams are not securities because they “do not exist and may never exist.” Rather, under the SAFTs, Telegram represented that it will create and distribute Grams only upon the launch of a “fully functional TON Blockchain,” which will provide Gram’s use-cases; that is, once the TON Blockchain is launched, Grams will be able to be used for, among other things, payment for physical and digital products and services, commission paid to TON validators for processing transactions and smart contracts, voting on parameters of the protocol, and payment for services provided by third-party applications on the TON Blockchain.

The SEC is expending significant resources in this case. It recently submitted to the Court expert opinions to support its position that token sales are offerings of securities subject to its regulation. Together, these opinions are intended to buttress the SEC’s argument that Telegram’s offering satisfied the Howey test and qualified for no exemption from registration:

  • A financial economist at the SEC’s Division of Economic and Risk Analysis, Carmen A. Taveras, Ph.D., provided an opinion that the price at which Grams are sold increases exponentially over time and is a function of the total number of Grams in circulation. As a result, the price at which purchasers who bought Grams pursuant to the SAFTs is significantly discounted to the price at which Grams will be available for purchase by subsequent buyers. The opinion also disputed Telegram’s representation in promotional materials that it will maintain price stability following the launch of the TON Blockchain by setting up a “TON Reserve” to strategically buy and sell Grams. Taveras concluded that the TON Reserve’s ability to buy and sell Grams would likely have a limited effect on curbing sudden spikes and dips in the price of Grams.
  • A blockchain data scientist in private practice, Patrick B. Doody, opined that while it is reasonable for private placement purchasers to buy Grams expecting to profit by selling them in the secondary market, Grams are unlikely to attract investors seeking a “realistic currency option to buy goods and services.” Telegram’s promotional materials appealed to potential investors seeking to profit through resales, while providing short shrift to factors that would enhance Grams’ viability as a currency, including fraud prevention, theft, integration with existing banking relationships, compliance with financial regulations, and price stability such as that which can be achieved by pegging the price of Grams to a fiat currency.
  • An expert in the field of computer science at Brown University, Maurice P. Herlihy, Ph.D., opined that the publicly released version of the TON Blockchain code lacks critical components that would be required in a fully developed and running system, and users cannot evaluate the security and effectiveness of the TON Blockchain in its current state. Moreover, the TON Blockchain is not yet mature enough to support the suite of services described in TON public documents.

Taken together, the SEC’s experts took the position that (1) Telegram SAFT investors reasonably expected to profit from Telegram’s efforts to develop the TON Network, and (2) that the current state of the TON Network reveals it is not yet mature enough to support the suite of services promised by TON’s public documents.

Telegram also retained its own expert, Stephen McKeon, who holds a Ph.D. in management with a finance focus and a master’s degree in economics. McKeon’s expert report rebuts the SEC’s experts by opining that (1) the profit expectations of SAFT investors is independent from, and not relevant to, the expectations of purchasers following the TON Blockchain launch, and (2) that most TON Network “components are complete or nearing their completion and will be fully available to the TON blockchain users at the launch of the mainnet.”

As further evidenced by the filing of amicus briefs by the Chamber of Digital Commerce and the Blockchain Association, the stakes for the industry in this case are high.

Fraud is Fraud – Sales of Unregistered Digital Securities Resemble Classic Microcap Fraud

A Complaint filed by the SEC in the Southern District of New York last week reminds us that in the area of securities law violations there is not much new under the sun. Even though the action against Eran Eyal and UnitedData, Inc. d/b/a “Shopin” involves the sale of digital assets, and the business of the issuer of those digital assets purportedly involves a blockchain application, the alleged wrongful conduct bears the hallmarks of a traditional securities offering scheme; one can substitute “unregistered securities” for the tokens offered, “private placement” for the token pre-sale, and a speculative venture – such as the “self-cooling can” that was the subject of an SEC offering fraud case years ago – for the blockchain applications touted by the issuer, and the Complaint is one that could have been drafted thirty years ago. To the extent that certain recent cases involving offerings of cryptocurrencies have presented novel applications of the securities laws and the Howey test of whether a digital currency is a security, this case isn’t one of them.

A description of the alleged misconduct makes the parallels clear. The SEC alleges that the issuer, Shopin, and its CEO, Mr. Eyal, conducted a fraudulent and unregistered offering of digital securities. The company’s business plan involved the creation of personal online shopping profiles that would track customers’ purchase histories across numerous online retailers, and link those profiles to the blockchain. However, Shopin allegedly never had a functioning product. The company’s pivot to the blockchain and rebranding resulted from its struggles to stay in business as a non-blockchain business.

The company apparently commenced its digital securities offering with a “pre-sale” of tokens through an unregistered offering, not unlike the private placement of securities that is often alleged as the first step in an offering fraud. Shopin’s initial sales of investment interests were made pursuant to a SAFT – a simple agreement for future tokens – in which initial investors paid bitcoin or ether in exchange for an interest in tokens at a discount that would be delivered once Shopin created the tokens at the completion of the public ICO. The proceeds of this pre-sale purportedly would be used to develop, launch and market the Shopin network, similar to the types of promises made in microcap or blind pool offerings. Unsold tokens in the pre-sale would go to insiders at Shopin and its advisors. The SEC determined that the Shopin tokes were investment contracts under the Howey test, because the purchasers invested money in the form of digital currency, the investors’ funds would be pooled in a common enterprise, and the defendants led the token purchasers to expect profits from their purchases because of the defendants’ efforts.

In its complaint, the SEC treated the token sale – which, again, was not registered under the securities laws – as a private placement subject to Regulation D, and alleged that the defendants failed to ensure that the purchasers of the tokens were accredited investors. Indeed, the SEC alleged that certain investors tried to satisfy the minimum investment requirements by pooling their investments in syndicates. This is a variant of the artifices employed by microcap issuers to artificially achieve a minimum offering level by making nominee purchases. The defendants also, in another resemblance to a microcap scheme, allegedly told investors they intended to have the Shopin tokens listed on digital-asset trading platforms – analogous to a promise to list penny stocks on an exchange – which purportedly would enable investors to realize profits on their positions by selling the tokens at a premium.

Having established that the ICO had the elements of a securities offering, the SEC described the material misrepresentations that the defendants made to investors: that the company had participated in successful pilot programs with prominent retailers; that the defendants had partnerships with numerous retailers; and that it was advised by a prominent individual in the digital asset field, who in fact had asked the company to remove his name as an advisor. Finally, and most serious, the SEC alleged that the defendants had misused portions of the offering proceeds, including for personal expenses, such as an individual’s rent, shopping and entertainment and – the type of salacious detail the SEC likes to include – to pay for a dating service.

Securities schemes tend to fall into certain patterns that involve the use of unregistered securities and misrepresentations to separate investors from their money, and schemes involving digital currency that resembles a security often fall into the same patterns. Perhaps recognizing that those patterns are recognizable to triers of fact and the public, the SEC alleges violations involving digital currency in similar terms. SEC Chairman Jay Clayton has repeatedly emphasized that the regulator will use its traditional tools and standards in treating sales of digital assets that conform to the definition of a security: for example, as he stated last year, “A token, a digital asset, where I give you my money and you go off and make a venture, and in return for giving you my money I say ‘you can get a return’ that is a security and we regulate that. We [the SEC] regulate the offering of that security and regulate the trading of that security.” Legitimate sales and offerings of digital currency might use a different vocabulary and analysis but, as the allegations in the case discussed here show, fraud is fraud.

SEC Division of Enforcement 2019 Annual Report Shows Cryptocurrency Is Still Under the Microscope

The SEC Division of Enforcement’s 2019 Annual Report, released earlier this month, shows a continuing focus on activities involving blockchain and cryptocurrency, and its website shows an increase in cases since last fiscal year. The Annual Report provides an overview of the SEC’s enforcement activities during FY 2019, highlighting enforcement priorities and trends, noteworthy actions, and enforcement challenges. The SEC’s attention to enforcing the securities laws in the blockchain and cryptocurrency space features prominently in the Annual Report, securing special attention both in the introductory message from Division Co-Directors Stephanie Avakian and Steven Peikin, and as one of two “initiatives and areas of focus in Fiscal Year 2019” (alongside the SEC’s traditional focus on protecting retail investors).

But while Co-Directors Avakian and Peikin state that the Division’s “activities in the digital asset space matured and expanded” in 2019, the nature of its enforcement priorities as detailed in the 2019 Annual Report is not markedly different from the previous year. To be sure, the 2019 Annual Report highlights some of the more high-profile enforcement actions in the industry, such as the SEC’s ongoing case against Kik Interactive for allegedly conducted an illegal $100 million securities offering in 2017. And, as reported on the SEC website, the number of enforcement actions the SEC designates as relating to “Digital Assets/Initial Coin Offerings” has seen an uptick since last year (with 13 filed in FY 2018, and 21 in FY 2019).

One thing that the 2019 Annual Report more clearly highlights about the SEC’s activities this year is the Division of Enforcement’s attention to non-fraud violations related to cryptocurrencies. For example, the SEC charged the founder of a digital asset trading platform for operating as an unregistered national securities exchange, and charged an “ICO Incubator” and its founder for acting as an unregistered broker-dealer and selling unregistered digital asset securities. And for the first time, the SEC filed charges for the unlawful promotion of ICOs (against boxer Floyd Mayweather Jr. and music producer DJ Khaled).

With cryptocurrencies being one of the SEC’s “initiatives and areas of focus” and the fact that the Division’s Cyber Unit only became fully operational in Fiscal Year 2018, the volume of enforcement actions in this space may well continue to increase in FY 2020. Even if not, participants in the industry should be mindful that the SEC is still scrutinizing cryptocurrency activities and is able and willing to penalize non-fraud violations of the securities laws. As Co-Directors Avakian and Peikin noted in the Report: “Collectively, these actions send the clear message that, if a product is a security, regardless of the label attached to it, those who issue, promote, or provide a platform for buying and selling that security must comply with the investor protection requirements of the federal securities laws.”

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.