Cryptocurrencies: Are They Securities?

Cryptocurrencies, including Bitcoin, have been in the news a lot lately, but many people still don’t know what they are—or whether they’re regulated.  Here’s a quick rundown.

What Are Cryptocurrencies?

Cryptocurrencies are decentralized digital cash systems.  Eschewing centralized control, such as a bank or government, cryptocurrencies instead rely on pseudonymous peer-to-peer networks—think Napster of yore—in which all actors in the network must recognize and reflect a transaction.  To illustrate how this works, if Person A has an apple and trades it to Person B for her orange, Person A cannot thereafter trade that apple to Person C because everyone knows from a public ledger that Person A has already traded his one apple.

The security of the public ledger is then of paramount importance—so how do cryptocurrencies ensure ledger security?  They rely on people called miners.  Miners are basically the bookkeepers of the public ledger, and anyone with the time, energy, and equipment can be a miner.  When a transaction occurs, it is not immediately added to the public ledger; instead, a miner must first confirm it.  To do so, miners generate a complicated code that: (1) memorializes the data relating to the transaction; (2) refers to the previous confirmed transaction in the system (a sequential timestamp of sorts); and (3) complies with the particular cryptocurrency’s specific requirements.  This is a challenging and necessary task that protects the public ledger—a transaction won’t be confirmed if a code can’t be generated that aligns with previous ledger entries.  Using the earlier example, once Person A’s apple-orange trade has been confirmed, he can’t trade the apple again because any code generated after that reflects that he has already traded his apple.  Without an acceptable code, no new transaction can be confirmed.

Miners race against each other to confirm transactions because each confirmation earns the miners a specified amount of the cryptocurrency, which is finite in supply.  Once confirmed, the transaction is permanently recognized and irreversible.  In essence, cryptocurrencies attempt to ensure legitimacy through a crowd-sourced ledger in which lines may not be deleted and may be added sequentially only after users, who are paid for their efforts, solve recognized and complicated puzzles.

Are Cryptocurrencies Regulated as Securities?

Cryptocurrency values have skyrocketed this year: Bitcoin has tripled in value and the value of Ethereum, another cryptocurrency, has jumped by more than 2,000 percent.  The resulting buzz has attracted government attention around the globe.  Recognizing both the potential risks and rewards, many countries have begun attempts to regulate cryptocurrencies, to varying degrees.

In the US, both the SEC and FINRA have warned investors about the greater risks—due to anonymity, volatility, and lack of central authority—surrounding any investment in cryptocurrencies.  More recently, the SEC has also issued guidance on digital coin sales, or initial coin offerings (ICOs), and has taken the position that “offers and sales of digital assets by ‘virtual’ organizations are subject to the requirements of the federal securities laws.”

For example, in its Report of Investigation of Slock.it UG, a German corporation, and the DAO, an affiliated “virtual” organization, the SEC “stress[ed] that the U.S. federal securities law may apply to various activities, including distributed ledger technology, depending on the particular facts and circumstances . . . .”  It then “demonstrate[d] the application of existing U.S. federal securities law to this new paradigm” by using Slock.it and the DAO’s ICO as an example:

The DAO was created by Slock.it and [its] co-founders, with the objective of operating as a for-profit entity that would create and hold a corpus of assets through the sale of DAO Tokens to investors, which assets would then be used to fund “projects.” The holders of DAO Tokens stood to share in the anticipated earnings from these projects as a return on their investment in DAO Tokens.

Analyzing these facts in the context of federal law, the agency concluded that the DAO tokens constituted securities.  The securities laws therefore applied “to those who offer and sell [the tokens] in the United States,” regardless “whether the entity is a traditional company or decentralized autonomous organization,” “whether . . . purchased using U.S. dollars or virtual currencies,” or “whether [the tokens] are distributed in certificated form or through distributed ledger technology.”  While the SEC did not bring charges in this instance, its report was intended to send the message that the SEC is keeping its eye on cryptocurrencies, and that we may see future enforcement actions in this area.

Foreign governments have likewise increased regulation, though to differing degrees and with different goals.  China, home to one of the largest cryptocurrency trading markets, has taken steps to clamp down on such trading.  Just last week, Chinese authorities ordered all domestic cryptocurrency exchanges to immediately cease trading.  Exchanges were also directed to come up with a plan for the orderly return of funds to investors.  By contrast, Russia has taken the opposite approach.  Despite skepticism from the central bank, President Vladimir Putin has signaled his support of cryptocurrencies and more widespread adoption.

Supreme Court to Decide Whether Covered Class Actions May Be Litigated in State Court

As the beginning of the next US Supreme Court term nears, one case in particular has caught our attention, as the question presented asks whether state courts have jurisdiction over certain securities class actions. The case before the Supreme Court that will hopefully decide the matter is Cyan v. Beaver County Employees Retirement Fund. The ultimate question is—will the Supreme Court issue an opinion that stays the trend of plaintiffs pursuing 1933 Act cases in state court over federal court? READ MORE

“It’s Complicated:” The Evolving Case Law on How Relationships Impact Insider Trading Liability

Last Wednesday, former SAC Capital Advisors manager Mathew Martoma lost a bid to overturn his 2014 insider trading conviction in the Second Circuit.  United States v. Martoma, No. 14-3599, 2017 WL 3611518 (2d Cir. Aug. 23, 2017).  Martoma, the latest in a string of important insider trading decisions, is significant because the Second Circuit departed from the “relationship test” that had been central to Second Circuit insider trading cases in recent years.  See United States v. Newman, 773 F.3d 438 (2d Cir. 2014).  The departure was based on a 2016 Supreme Court decision, Salman v. U.S., in which the Court rejected the “relationship test” as set forth in Newman, and reaffirmed the standard set in Dirks v. SEC, 463 U.S. 646, 103 S. Ct. 3255, 77 L. Ed. 2d 911 (1983), holding that where a close relationship exists between the tipper and tippee, the government is not required to show that the insider received a benefit of a “pecuniary or similarly valuable nature.”  Martoma had appealed his conviction before Salman was issued, and relied heavily on the Second Circuit’s relationship test outlined in Newman.

In Newman, the Second Circuit overturned the insider trading convictions of two portfolio managers who were “remote tippees,” individuals who traded on inside information but with one or more layers of individuals between them and the insider who originally provided the information.  The insiders in Newman were friends with the tippees but did not gain any personal benefit in exchange for the information provided.  The government argued in that case that it only needed to show that the tippees traded on “material, nonpublic information they knew insiders had disclosed in breach of a duty of confidentiality.”  However, the Second Circuit rejected that argument, explaining that the government was required to show that the insider shared confidential information in exchange for a personal benefit, and that the remote tippees were aware of that fact.  The Second Circuit also held that where there is no quid pro quo exchange for confidential information given by a tipper to a tippee, such information only amounts to a “personal benefit” when the tipper has a “meaningfully close personal relationship” with the tippee.  To meet the test, that relationship must “generat[e] an exchange that is objective, consequential, and represents at least a potential gain of a pecuniary or similarly valuable nature.”  (Emphasis added.)  Essentially, if there was no potential for financial gain resulting from the gift of information, no personal benefit existed under Newman.  In the immediate aftermath of Newman, many insider trading prosecutions within the Second Circuit became untenable and were dropped.

Martoma’s appeal relied heavily on Newman, which was decided after his original conviction.  He claimed that he and the tipper, a doctor, did not have a “meaningfully close personal relationship,” and that the doctor had not received any personal benefit in exchange for the confidential information he provided Martoma.  Martoma also argued that even if the evidence was sufficient to uphold his conviction, the district court’s jury instructions were insufficient because they did not instruct the jury regarding the “personal benefit” requirement under Newman.  However, while Martoma’s appeal was pending, the Supreme Court issued its decision in Salman v. United States, 137 S. Ct. 420, 196 L. Ed. 2d 351 (2016).  Salman explicitly rejected Newman’s requirement that the tipper must receive something of a “pecuniary or similarly valuable nature” in exchange for a gift to family or friends.  The Court held that providing information to a relative or friend who later trades on it is sufficient to satisfy the personal benefit requirement, although it did not specify how close the relationship must be.  After Salman was decided, Martoma offered supplemental briefing in the Second Circuit, arguing that his conviction still should be reversed because Salman did not overrule Newman’s “meaningfully close personal relationship” requirement.

The Second Circuit rejected Martoma’s argument and held that Salman overruled Newman to the extent Newman required a “meaningfully close personal relationship” between the tipper and tippee.  The court further held that there was no clear error in the jury instructions, and that any alleged error would not have changed the outcome of the trial because the government presented “overwhelming evidence that at least one tipper had received a financial benefit from providing confidential information to Martoma.”

While on its face Martoma appears to have opened the door to a broader range of insider trading prosecutions than were possible under preexisting Second Circuit case law, Judge Pooler’s 44-page dissent calls into question what the effect of the decision will be.  Her dissent argues that the Second Circuit panel went far beyond the limitation previous Supreme Court precedent set, which she said had not been disturbed by Salman.  That limitation was that an insider only receives a personal benefit from gifting information when it is gifted to family or friends—as these people are very unlikely to use the information for valid commercial reasons.  Furthermore, in the dissent’s view, the majority opinion “radically alters insider-trading law for the worse.”  Judge Pooler’s scathing dissent could indicate that the Second Circuit will convene an en banc panel to review the decision.  If en banc review is denied or if the panel affirms the decision, it is expected that Martoma will appeal to the Supreme Court.  In any event, the Martoma opinion may not be the final word on this topic.

SEC Updates Revenue Recognition Guidance for Bill-and-Hold Arrangements

Last Friday, the SEC issued two releases regarding guidance on revenue recognition, along with a related Staff Accounting Bulletin. These releases are notable for all SEC registrants, as they update prior revenue recognition guidance.

First, the SEC updated its guidance for criteria to be met in order to recognize revenue when delivery has not occurred, i.e., bill-and-hold arrangements. The SEC’s guidance now follows that of the Financial Accounting Standards Board (“FASB”) Accounting Standards Codification (“ASC”) Topic 606, Revenues from Contracts with Customers. Per ASC Topic 606, revenue may be recognized when or as the entity satisfies a performance obligation by transferring a promised good or service to a customer, and a good or service is transferred when the customer obtains control of that good or service. In the context of bill-and-hold arrangements, ASC Topic 606 provides specific guidance that certain indicators must be met to show that control has been transferred, including: (i) a substantive reason for such an arrangement where the customer has declined to exercise its right to take physical possession of that product; (ii) the product must be identified separately as belonging to the customer; (iii) the product currently must be ready for physical transfer to the customer; and (iv) the entity cannot have the ability to use the product or direct it to another customer. Until a registrant adopts ASC Topic 606, however, it should continue to follow the older guidance for revenue recognition. In conjunction with the SEC’s release, the SEC’s Office of the Chief Accountant and Division of Corporate Finance also released a bulletin that brings existing SEC staff guidance into conformity with ASC Topic 606.

The SEC also published new guidance with respect to accounting for sales of vaccines and bioterror countermeasures to the Federal Government for placement into the pediatric vaccine stockpile or the strategic national stockpile. In light of the updated ASC Topic 606 referenced above, the SEC states that vaccine manufacturers should now recognize revenue and provide disclosures when vaccines are placed into Federal Government stockpile programs because control of the enumerated vaccines (i.e., childhood disease, influenza and others) will have been transferred to the customer.

Second Circuit Ruling Creates Challenge for Securities Class Action Plaintiffs

The Second Circuit recently considered the extraterritorial application of the U.S. securities laws in the private securities class action context, bringing some clarity to an area of the law that is increasingly important given the globalization of financial markets.

In re Petrobras Securities, 862 F.3d 250 (2nd Cir. 2017), was an appeal of a class certification order in a securities class action related to an alleged multi-year money-laundering and kickback scheme involving Petróleo Brasileiro S.A. (“Petrobras”), the Brazilian state-owned oil and gas company. The district court had certified two classes of investors who purchased Petrobras American Depository Shares (ADS) and debt securities, and who brought misrepresentation claims under the Securities Act of 1933 and the Securities Exchange Act of 1934 against Petrobras, its subsidiaries, and its underwriters. Morrison v. National Australia Bank Ltd., 561 U.S. 247 (2010), held that the anti-fraud provisions of the securities laws have no extraterritorial effect, and as a consequence apply only to transactions in securities that occur on a U.S.-based exchange or that are otherwise “domestic.” Petrobras ADS shares satisfied the first requirement, but the company’s debt securities are traded over-the-counter, not on a U.S. exchange. Prior decisions had limited “domestic” transactions to ones where (1) the purchaser “incurred irrevocable liability within the United States to take and pay for a security . . . or to deliver a security” or (2) “legal title to the security . . . transferred in the United States” (see, e.g., Absolute Activist Value Master Fund Ltd. v. Ficeto, 677 F.3d 60, 68 (2d Cir. 2012)), but how this test implicated the standards for class certification was not clear. READ MORE

The “Pharma Bro” Trial—Who Really Won?

After a five-week trial, a jury of five men and seven women convicted notorious pharmaceutical executive Martin Shkreli of securities fraud on August 4, 2017. Shkreli had been charged with two counts of securities fraud, three counts of conspiracy to commit securities fraud, and three counts of conspiracy to commit wire fraud for operating a sophisticated Ponzi scheme in which he looted the assets of his pharmaceutical company to pay off defrauded investors in his hedge funds. The jury convicted Shkreli of two counts of securities fraud and one count of conspiracy to commit securities fraud but acquitted him of five other counts, including the wire fraud charges.

Shkreli gained notoriety in 2015, when he was head of Turing Pharmaceuticals, for increasing the price of a life-saving drug from $13.50 to $750 per pill. However, Shkreli’s conviction stems from his time before Turing, when he managed two hedge funds, MSMB Capital Management and MSMB Healthcare Management. The government alleged that between 2009 and 2012, Shkreli induced investments of around $3 million from eight investors in MSMB Capital and $5 million from thirteen investors in MSMB Healthcare by misrepresenting key facts, including the funds’ performance and assets under management, and omitting key facts, such as significant trading losses at another fund Shkreli had previously managed. Shkreli allegedly also withdrew money from the funds for personal use and produced false performance reports touting profits as high as forty percent. MSMB Capital ceased trading after a series of trading losses in early 2011, and MSMB ceased operating in late 2012. In September 2012, Shkreli notified both funds’ investors that he was winding down the funds, that he had doubled their investments net of fees, and that investors could have their interests redeemed for cash, even though the funds had no money. At trial, Shkreli’s attorney argued that the hedge funds’ investors had not only received all of their money back but made significant profits. READ MORE

On the Chopping Block: The Effort to Repeal the CFPB’s New Rule on Consumer Class Actions

On July 19, 2017, the Consumer Financial Protection Bureau (“CFPB”) published a new rule that has the potential to significantly increase the number of class action lawsuits brought by consumers against their financial services providers.  Although consumer advocates applaud the rule, critics argue that the rule will lead to an explosion of frivolous lawsuits.  Congress, for its part, is currently taking steps to stop the rule from ever taking effect.

The rule would no longer allow a financial services provider to use mandatory arbitration clauses to stop its consumers from bringing class action lawsuits against that provider. Mandatory arbitration clauses require that disputes between parties to a contract must be resolved by privately appointed arbitrators rather than the courts, with few exceptions.  According to the CFPB, financial services providers have used arbitration clauses in consumer contracts to block class action lawsuits, forcing each consumer to pursue individual claims.  A CFPB study from March 2015 further claims that mandatory arbitration clauses are harmful to consumers because companies avoid paying full relief to all those harmed and are therefore not sufficiently deterred from engaging in the misconduct moving forward. READ MORE

What Startups Need to Know About the Revised Reg D

Startups need funding, and most startups want to raise money with as little legal red tape as possible. But when a startup takes investment money, it is issuing securities, and federal securities laws generally require a company – or “issuer” – to register the offering and sale of any securities with the Securities Exchange Commission (“SEC”). The bad news is that most early-stage companies don’t have the legal resources to comply with the SEC’s registration and reporting requirements. The good news is that Congress and the SEC recognize this and so have created certain exemptions from the registration requirement.

The most commonly used exemptions derive from Sections 4(a)(2) and 3(b)(1) of the Securities Act of 1933. Section 4(a)(2) exempts issuer transactions “not involving any public offering,” while Section 3(b)(1) authorizes the SEC to create additional exemptions. The SEC adopted Regulation D (“Reg D”) in 1982 to clarify and expand the exemptions available under these two sections. The SEC further expanded Reg D in 2013 following passage of the Jumpstart Our Business Startups Act of 2012 (“JOBS Act”).

Until this year, Reg D included three rules – Rules 504, 505, and 506 – that provided specific exemptions from registration. Rules 504 and 505 exempted certain offerings up to $1 million and $5 million, respectively. Rule 506 spelled out two “safe harbors” – 506(b) and 506(c). If an offering met the conditions of either of Rule 506’s “safe harbors,” it would be deemed a transaction “not involving any public offering” and would be exempt under Section 4(a)(2). READ MORE

Chairman Clayton Sets New SEC Agenda

On Wednesday July 12, 2017, in his first public speech as Chairman of the SEC, SEC Chairman Jay Clayton laid out a set of eight priorities that will guide his SEC Chairmanship.[1] He said his priorities are consistent with and complimentary to the seven “core principles” set forth in President Donald Trump’s February 3, 2017 executive order regarding the regulation of the U.S. financial system.

The overarching themes in Chairman Clayton’s speech are that he is focused primarily on capital formation, modernizing the trading and markets system, and he favors a disclosure and market-based approach to federal securities regulation . Given the kind words for former Chair Mary Jo White and multiple references of areas of agreement, it is difficult to determine how much of a shift one can expect from the Commission under Chairman Clayton. Nevertheless, the following are a few key takeaways from the speech.

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Time’s Up: Supreme Court Affirms Three-Year Deadline for Opting Out of Section 11 Class Actions

On June 26, 2017, the U.S. Supreme Court issued a decision that will have a significant effect on securities class action litigation, changing the strategic calculus for both institutional plaintiffs and defendants. In California Public Employees’ Retirement System v. Anz Securities, Inc., No. 16-373, 582 U.S. ___ (2017) , the Court held that American Pipe tolling does not apply to the 3-year statute of repose for private damage claims under the Securities Act of 1933.  Thus, the filing of a class action complaint under Section 11 of the Securities Act of 1933 does not toll the three-year statute of repose for individual claims that may be brought by putative class members who later decide to opt out of a class-wide settlement.

CalPERS arose out of two public securities offerings issued by Lehman Brothers Holdings in 2007 and 2008.  In September 2008, with Lehman in bankruptcy, a Section 11 class action was filed against Anz Securities and other underwriters to the offerings, alleging that the registration statements included material misstatements or omissions.  The class action complaint was consolidated with other securities suits against Lehman into a single multidistrict class action in the Southern District of New York.  CalPERS, an unnamed member of the putative class, subsequently filed a separate complaint alleging identical causes of action against the respondents in the Northern District of California in February 2011—more than three years after the offerings closed.  CalPERS’ individual suit was transferred to the Southern District of New York and consolidated with the multidistrict litigation.  CalPERS opted out of the class only after the class action reached a settlement.

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