Keyword: Securities, Derivatives and Financial Institutions

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.”

Still Waiting: SEC Again Delays Approvals of Bitcoin ETFs

As further evidence of the SEC’s resistance to the development of a regulated secondary market in bitcoin, on August 12 it delayed making a decision on three additional bitcoin exchange-traded fund (ETF) proposals.

On January 28, 2019, NYSE Arca, Inc. filed a proposed rule change under the Securities Exchange Act of 1934 to list and trade shares of the Bitwise Bitcoin ETF Trust. Also, on January 30, CBOE BZX Exchange, Inc. filed a proposed rule change under the Exchange Act to list and trade shares of SolidX Bitcoin Shares issued by the VanEck SolidX Bitcoin Trust. Finally, on June 12, NYSE Arca, Inc. filed a proposed rule change to list and trade shares of the United States Bitcoin and Treasury Investment Trust.

The Exchange Act mandates that a final decision be made within 240 days of such filings. In the case of the first two proposals, the SEC exercised its discretion and found it appropriate to designate the remaining time available under the 240-day maximum period “so that it has sufficient time” to consider it. Based upon the same rationale, the SEC delayed action on the other NYSE Arca proposal for 45 days. Accordingly, it designated October 13, October 18 and September 29, 2019, with respect to the Bitwise Bitcoin ETF Trust, the VanEck SolidX Bitcoin Trust and the United States Bitcoin and Treasury Investment Trust, respectively, as the dates by which it “shall either approve or disapprove the proposed rule change.”

These delays come as no surprise given the SEC’s disapprovals of similar proposals to list other bitcoin ETFs, most notably the multi-year effort of investors Cameron and Tyler Winklevoss to list the Winklevoss Bitcoin Trust on the Bats BZX Exchange, Inc. In rejecting these proposals, the SEC has cited numerous concerns, including the risk of market manipulation, market surveillance and a potential divergence with futures trading as some issues. It remains to be seen whether the SEC will have the same concerns when it rules on the pending proposals.

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.

SEC/FINRA Joint Statement on Digital Asset Securities Does Not Address Regulatory Log Jam

Last week, the Staffs of the Securities and Exchange Commission (SEC) and the Financial Industry Regulatory Authority (FINRA) (collectively, the Staffs) released a Joint Statement concerning the application of the SEC’s Customer Protection Rule and other federal laws and regulations to transactions in digital asset securities. The Joint Statement is the result of months of dialogue among the Staffs and industry participants regarding the practical application of the federal securities laws to emerging digital technologies. Nonetheless, it gives no indication as to when FINRA expects to begin working down its backlog of applications from broker-dealers seeking to facilitate markets in digital asset securities.

The Customer Protection Rule

The Joint Statement primarily addresses the application of SEC Rule 15c3-3, the Customer Protection Rule, to federally registered broker-dealers taking custody over their customers’ digital asset securities. The Customer Protection Rule requires broker-dealers to segregate customer assets in specially protected accounts, thereby increasing the likelihood that customers will be able to withdraw their assets even if the broker-dealer becomes insolvent. To comply with the rule, broker-dealers must either physically hold customers’ fully paid and excess margin securities or deposit them at the Depository Trust Company, a clearing bank, or other “good control location” free of any liens or encumberments. This infrastructure additionally protects customers by allowing mistaken or unauthorized transactions to be reversed or canceled.

While the Customer Protection Rule applies to both traditional and digital asset securities, the Staffs advised that broker-dealers taking custody over digital asset securities may need to take additional precautions to respond to unique risks presented by these emerging technologies. For instance, there may be greater risk that a broker-dealer maintaining custody of digital asset securities could become the victim of fraud or theft or could lose the “private key” required to transfer a client’s digital asset securities. Further, another party could hold a copy of the private key without the broker-dealer’s knowledge and transfer the digital asset security without the broker-dealer’s consent. The Staffs noted that an estimated $1.7 billion worth of digital assets was stolen in 2018, of which approximately $950 million resulted from cyberattacks on bitcoin trading platforms. These risks could cause customers to suffer losses and create liabilities for the broker-dealer and its creditors.

The Staffs noted that broker-dealer activities that do not involve custody functions do not trigger the Customer Protection Rule. Examples of such activities include the facilitation of bilateral transactions between buyers and sellers similar to traditional private placements or “over the counter” secondary market transactions. These transactions do not “raise the same level of concern among the Staffs” as do transactions in which the broker-dealer assumes custody over the securities.

Other Federal Regulations

The Staffs advised broker-dealers to consider how distributed ledger technology may impact their ability to comply with broker-dealer recordkeeping and reporting rules. Because transactions in digital asset securities are recorded on distributed ledgers such as blockchains rather than traditional ledgers, broker-dealers may find it more difficult to evidence the existence of these digital asset securities on financial statements and to provide sufficient detail about these assets to independent auditors.

Finally, the Staffs discussed the application of the Securities Investor Protection Act (SIPA) to broker-dealers exercising custody over digital assets. In the event a broker-dealer is liquidated, SIPA gives securities customers first-priority claims to securities and cash deposited with the broker-dealer. However, the Joint Statement notes that SIPA’s definition of “security” is different than the federal securities laws definitions. For example, the definition in SIPA of “security” excludes an investment contract or interest that is not the subject of a registration statement with the Commission pursuant to the provisions of the Securities Act of 1933. Consequently, customers whose digital assets are subject to the Customer Protection Rule and other federal regulations may only have an unsecured general creditor claim against their broker-dealer’s estate in the event their broker-dealer fails. The Staffs found that such outcomes are likely inconsistent with the expectations of investors in digital assets that do not qualify for SIPA protection.

Waiting Game

Absent from the Joint Statement is a clear answer to the question at the forefront of many industry participants’ minds: When will FINRA begin approving the dozens of applications of existing broker-dealers and new registrants seeking authority to offer a variety of custodial and non-custodial services with respect to digital assets? Applicants seeking to engage only in non-custodial activities, such as market-making, may be encouraged that the Staffs have indicated that those activities pose the least concern to federal regulators, and, presumptively, may be more readily approved. Nonetheless, the Staffs have given no indication that FINRA will prioritize processing applications seeking authority to provide only non-custodial services currently in its backlog, or when such applications will once again be approved.

Meanwhile, the Joint Statement underscores that considerable uncertainty remains regarding the application of existing laws and regulations to broker-dealer activities involving the custody of digital assets. While the Staffs invite broker-dealers and other industry participants to continue to engage with federal regulators to develop workable methodologies for securely carrying customers’ digital assets, industry participants hoping to get a firm answer as to when secondary market trading in digital asset securities will gain federal regulators’ seal of approval will have to keep waiting.

 

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.

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.

SEC’s Light Touch: An ICO Settlement Without a Penalty

In another first for the digital token industry, on February 20 the SEC announced a settlement involving a self-reported unregistered initial coin offering (ICO) without imposing a penalty. Like its earlier settlements with AirFox and Paragon, the SEC required Gladius Network LLC to repay investors and register its GLA tokens as securities. This time, however, in a sign that the SEC is willing to work with companies trying to come into compliance, the SEC did not impose a monetary penalty due to the company’s “decision to self-report and its extensive cooperation with the staff’s subsequent investigation.”

Having just completed their freshman year at the University of Maryland College Park in 2017, Max Niebylski, Alex Godwin, and Marcelo McAndrew during their summer break founded Gladius as a cyber security company dedicated to ending Distributed Denial of Service attacks. On September 27, 2017 Gladius released a White Paper, and between October 13, 2017 and December 13, 2017 it raised a total of $12.7 million dollars through the sale of GLA tokens.

In an apparent attempt to maneuver around the securities laws and avail itself of the as-yet-untested utility token defense – which attempts to show that the tokens did not represent an investment contract but rather, like it sounds, something with utility for the purchaser – Gladius required participants in the ICO to warrant that they were purchasing GLA tokens “solely for the purpose of accessing Services . . . [and not for] any investment, speculative or other financial purposes.” Nevertheless, in the summer of 2018 Gladius self-reported the unregistered sale of GLA tokens to the SEC’s Division of Enforcement.

The SEC, in the settlement order, included a one-sentence Howey analysis, finding that the sale of GLA tokens met the factors of Howey because “[a] purchaser in the offering of GLA Tokens would have had a reasonable expectation of obtaining a future profit based upon Gladius’s efforts to create a ‘marketplace’ using the proceeds from the sale of GLA Tokens and to provide investors with liquidity by making GLA Tokens tradeable on secondary markets.”

Although the Company will have to comply with notice and reporting requirements under the federal securities laws, the only ordered monetary relief is the requirement that the Company refund GLA token purchases made between September 2017 and December 2017 pursuant to a claims process similar to what the SEC devised for the AirFox and Paragon settlements. Given the infrequency with which investors actually file claims, it is unlikely that the Company will end up refunding the full $12.7 million-dollar obligation it faces.

In another notable deviation from the AirFox and Paragon settlements, the SEC directed Gladius to provide the Commission advance notice if it planned to file a Form 15 to terminate its registration pursuant to Rule 12g-4 under the Securities Exchange Act of 1934 on the grounds that the GLA Tokens no longer constitute a “class of securities.” This seemingly superfluous requirement could be the SEC’s way of signaling to the industry that token issuances that remain below the monetary and holder threshold requirements of Rule 12g-4 will not run afoul of securities laws.

All told, the Gladius settlement is proof that the SEC continues to show leniency to token issuers who violated the securities laws if they act in good faith and come into compliance.