Last week, on September 11, 2018, a number of “firsts” occurred in the prosecution of cryptocurrency-related activities. The Securities and Exchange Commission (SEC) brought its first-ever enforcement action involving a registration violation for a cryptocurrency fund; the Financial Industry Regulatory Authority (FINRA) filed its first enforcement complaint against a registered representative for marketing and making false statements relating to unregistered cryptocurrency securities; and a federal court in Brooklyn was the first to permit a criminal indictment to proceed for an allegedly fraudulent cryptocurrency scheme. This legal alert analyzes these three cases and their impact on the regulation of cryptocurrencies moving forward.
SEC’s First Registration Violation
The SEC announced its first enforcement action for an investment company registration violation involving a hedge fund’s investments in cryptocurrency.1 The SEC’s settlement order found that Crypto Asset Management LP (CAM) offered a fund that operated as an unregistered investment company, while falsely claiming it was the “first regulated crypto asset fund in the United States.”
From August 1, 2017, through December 1, 2017, CAM raised more than $3.6 million from investors solicited via its website, social media accounts and traditional media outlet interviews. The SEC found that CAM’s hedge fund engaged in the business of “investing, holding, and trading” digital assets that qualified as “investment securities” under Section 3(a)(2) of the Investment Company Act. Since the fund’s digital assets exceeded 40% of its total value, the fund met the definition of an “investment company.” But CAM failed to register the fund, meet any statutory exemptions or seek an exemption order from the SEC. The SEC further found that CAM negligently misrepresented to investors the fund’s purported status as the “first regulated crypto asset fund in the United States.” Beginning in January 2018 after being contacted by the SEC, the fund halted the offering and began offering securities pursuant to the Regulation D Rule 506(c) exemption from registration.
As a result, the SEC found that CAM violated Section 5 of the Securities Act and Section 7(a) of the Investment Company Act for registration violations, and Section 17(a)(2) of the Securities Act and Section 206(4) of the Advisers Act for making material misrepresentations. Without admitting or denying the findings, CAM agreed to the SEC’s cease-and-desist order, censure and a $200,000 civil penalty.
FINRA’s First Enforcement Action
FINRA made its first foray into the world of cryptocurrency regulation, filing an enforcement complaint against Timothy Tilton Ayre, a registered representative, for marketing an unregistered cryptocurrency security called “HempCoin,” and making fraudulent misstatements in promoting it.2
Ayre touted HempCoin as “the world’s first currency to represent equity ownership” in a publicly traded company, promising investors that each coin represented 0.10 share of his company Rocky Mountain Ayre, Inc. Investors mined 81 million HempCoins, which FINRA characterized as mining 81 million unregistered securities. Cryptocurrency mining is a computational process by which any member of the public may be rewarded with a defined amount of cryptocurrency in exchange for validating transactions on the network for the cryptocurrency. In addition to mining HempCoin, the cryptocurrency security was also available for purchase through several cryptocurrency exchanges. FINRA alleged that Ayre lured public investments in “his worthless public company” by making numerous fraudulent misstatements about the nature and finances of his company.
Among other charges, FINRA alleged that Ayre’s conduct violated Section 5 of the Securities Act for selling unregistered non-exempt securities, Section 10(b) and Rule 10b-5 thereunder of the Exchange Act for making material misrepresentation and omissions, as well as violations of related FINRA rules. The case will be heard by FINRA’s Office of Hearing Officers.
Unlawful Cryptocurrency-Related Activity Could Be Criminal
The United States District Court for the Eastern District of New York denied a defendant’s motion to dismiss a criminal indictment alleging that he made materially false and fraudulent representations and omissions in connection with two purported cryptocurrencies and their related initial coin offerings (ICOs).3 The defendant, Maksim Zaslavskiy, argued, in relevant part, that his two cryptocurrencies—operating under his companies “REcoin” and “Diamond Reserve Club” (DRC)—were tokens outside the purview of federal securities laws. The government, meanwhile, asserted that the cryptocurrencies were actually “investment contracts” under the Howey test4 and thus securities under federal securities laws.
The defendant in the case is accused of using his companies REcoin and DRC to induce investors to purchase non-existent digital tokens, purportedly backed by real estate and diamonds, respectively. The “investment opportunities” were allegedly based on material false statements—REcoin never purchased any real estate; DRC never purchased any diamonds; and no tokens were ever developed.
In denying the defendant’s motion to dismiss, the court stated: “The label [defendant] chooses to attach to the alleged scheme does not control our analysis. . . . Simply labeling an investment opportunity as ‘virtual currency’ or ‘cryptocurrency’ does not transform an investment contract—a security—into a currency.”5 The court found that the indictment was sufficiently pled and that the ultimate fact-finder could conclude that the cryptocurrencies at issue were, in fact, securities under the Howey test. The case will now proceed to trial where a jury will determine whether the tokens are indeed securities, subjecting the defendant to a potential criminal conviction for a cryptocurrency-related scheme.
Takeaways
What is to be made from these cryptocurrency regulatory “firsts”? With respect to the SEC, it continues its multi-faceted regulation of cryptocurrencies and ICOs and, indeed, appears to be broadening its scope. As funds investing in cryptocurrency continue to proliferate, investment companies (and their managers) must make sure their funds adhere to the applicable registration obligations regardless of what assets they invest in—including cryptocurrencies—and must accurately represent their funds’ regulatory status to investors.
FINRA’s enforcement action likely represents the first of many cryptocurrency-related actions. Its focus, however, given its narrower jurisdiction, is limited to any person or firm that is involved in cryptocurrency transactions, such as a registered representative. Now with FINRA not just watching but acting, broker-dealers should closely examine the regulatory impact of their conduct or business in the cryptocurrency space.
Finally, illegal cryptocurrency-related conduct is not just subject to injunctions and civil penalties. The Department of Justice appears poised to prosecute actors criminally for violations of federal securities laws. In those cases, juries, likely with little or no experience with securities laws, may end up deciding whether certain cryptocurrencies qualify as securities under the fact-intensive four-part Howey test.
Conclusion
Cryptocurrencies are being regulated more and more like old-fashioned securities. While these events may have constituted “firsts,” there will be “seconds” (and “thirds”) and additional “firsts” in the near future. More traditional types of securities enforcement regulation, including the panoply of potential civil or criminal prosecutions, will likely become the norm for unlawful cryptocurrency-related activities. It is clear that the public has an appetite for investing in cryptocurrencies. As regulators step up their enforcement efforts, it will be important for them to strike a balance between protecting investors and allowing the cryptocurrency sector to continue to mature and innovate.
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1In the Matter of Crypto Asset Management, LP, Sec. Act. Rel. No. 10544 (Sept. 11, 2018), available at https://www.sec.gov/litigation/admin/2018/33-10544.pdf.
2Department of Enforcement v. Timothy Tilton Ayre, Disciplinary Proc. No. 2016049307801 (Sept. 11, 2018), available at http://www.finra.org/sites/default/files/fda_documents/2016049307801%20Timothy%20Tilton %20Ayre%20CRD%202091556%20Complaint%20jm.pdf.
3United States v. Zaslavskiy, No. 17 CR 647 (RJD), Memorandum and Order (E.D.N.Y. Sept. 11, 2018). A parallel civil case brought by the SEC has been stayed pending the criminal proceedings. See SEC v. REcoin Group Foundation, et al., No. 17-cv-05725 (E.D.N.Y. Sept. 29, 2017).
4Under the Howey test, a transaction is an “investment contract” subject to federal securities laws if: (1) there is an investment of money, (2) in a common enterprise, (3) with an expectation of profits, (4) derived from the efforts of others. See SEC v. W.J. Howey Co., 328 U.S. 293 (1946).
5Zaslavskiy, No. 17 CR 647 (RJD), Memorandum and Order.
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