Technology evolves and events unfold at a dizzying pace in the blockchain world, but even by those standards this past week was tough to keep up with. Every day seemed to bring a new first for the industry – from new enforcement actions, key court decisions and the approval of two new stablecoins. This post summarizes the most notable actions that occurred this past week.
SEC Enforcement Action Against a Broker-dealer
On September 11, 2018, the SEC issued an order against TokenLot, LLC, a self-described initial coin offering (ICO) superstore, and its founders Lenny Kugel and Eli L. Lewitt, for operating an unregistered broker-dealer, the first time the SEC has made such an allegation in the cryptocurrency industry.
According to the order, TokenLot served as a platform for both token purchases and secondary trading in more than 200 different digital tokens. The SEC found that "through these activities, Respondents promoted and sold digital tokens that included securities." Unfortunately, the SEC did not specify which of the 200 digital tokens constituted securities, and thus deprived market participants of useful guidance.
The company and its two owners consented to the SEC's order, which assessed sanctions of over $560,000 without them having to admit or deny wrongdoing. The damage apparently could have been worse; the SEC stated that "the penalties in this case reflect the prompt cooperation and remedial actions ... [and the] valuable information" provided to the Commission staff. This apparently reduced penalty sends a message to the industry about the value of getting ahead of any problems with the SEC by self-reporting and cooperating.
SEC Action Against Hedge Fund Manager
In another first for the agency, on September 11, 2018 the SEC brought and settled charges against a hedge fund manager that invested in cryptocurrencies for failure to register the fund as an investment company with the Commission and lying about it.
The SEC charged Crypto Asset Management, LP (CAM), a digital asset investment fund, and its founder Timothy Enneking with falsely claiming to be the first regulated cryptocurrency fund in the U.S., while actually operating as an unregistered investment company. The SEC said that the fund met the Investment Company Act's definition of "investment company" as any issuer which is engaged in the business of investing, reinvesting, owning, holding or trading in securities. By engaging in an unregistered non-exempt public offering and investing more than 40 percent of the fund's assets in digital asset securities, the SEC found that CAM caused the fund to operate as an unregistered investment company. The SEC also found that as a result of this conduct, respondents willfully violated the Investment Advisers Act by making untrue statements of material fact to investors in the pooled investment vehicle. However, the SEC again failed to provide market participants with valuable guidance by not identifying which of the digital assets the fund invested in constitute securities.
This action highlights the regulatory uncertainty around digital assets. Even those market participants that seek regulatory counsel prior to dealing in digital assets, such as CAM, are still at risk that their analysis might turn out to be wrong. Without admitting fault, CAM and Enneking agreed to pay a penalty of $200,000.
First FINRA Cryptocurrency Enforcement Action
In another industry first, FINRA filed a disciplinary action involving cryptocurrencies on September 11, 2018. FINRA alleged that Massachusetts resident Timothy Tilton Ayre committed securities fraud and unlawful distribution of an unregistered security, HempCoin. This contested action carries out FINRA's stated 2018 goal of homing in on the cryptocurrency market.
In contrast to the SEC actions, FINRA does identify a specific token, HempCoin, as a security. This was not a reach, as the facts of the case leave little doubt that HempCoin is a security; as stated in the complaint, "Ayre marketed HempCoin as 'the world's first currency to represent equity ownership' in a publicly traded company, and represented that each coin was equivalent to 0.10 shares of RMTN common stock." As FINRA points out, by attaching the right to convert HempCoin into shares of stock, Ayre "transformed the cryptocurrency into a security."
EDNY Rejects Argument That Certain Cryptocurrencies Are Not Securities
Also on September 11, 2018, in a much awaited decision Judge Raymond Dearie of the United States District Court for the Eastern District of New York issued a Memorandum and Order in U.S. v. Zaslavskiy, denying Zaslawskiy's motion to dismiss the indictment.
In his motion, Zaslavskiy argued that the investments he offered, in REcoin Group Foundation, LLC (REcoin), and Diamonds Reserve Club (Diamond), were currencies, not securities, and therefore the Securities Exchange Act should not apply. Zaslavskiy also argued that the U.S. securities laws are unconstitutionally vague as applied to cryptocurrencies, and therefore the indictment should be dismissed.
As expected, the court applied the Howey test to determine whether the investment opportunities constituted "investment contracts." The court held that a reasonable factfinder could determine that the REcoin and Diamond offerings constituted securities offerings.
Regulatory Action: NYDFS Authorizes Two Stablecoins
On September 10, 2018, the New York Department of Financial Services authorized Gemini Trust Co. LLC and Paxos Trust Co. LLC to offer a stablecoin cryptocurrency that is pegged to the U.S. dollar.
Cryptocurrencies are notoriously volatile. As their names suggest, stablecoins provide much-needed stability to cryptocurrency market participants by allowing them to place their investments in a relatively stable digital asset. Gemini CEO Tyler Winklevoss stated that they "are excited to bring the Gemini dollar to market, a stablecoin that combines the creditworthiness and price stability of the U.S. dollar with blockchain technology and the oversight of the NYDFS." The introduction of such a stablecoin is undoubtedly welcome news to market participants who have had to rely on Tether, a stablecoin that has had its share of controversy.
The NYDFS approval requires the companies to meet regulatory conditions, and the companies will be subject to inspection by the department as well as independent consultants. The requirements include, among other things, ensuring the stablecoins are fully exchangeable for a U.S. dollar, and implementing, monitoring and updating effective risk-based controls to prevent the tokens from being used in connection with money laundering or terrorist financing.
SEC Chairman Clayton Issues "Statement Regarding SEC Staff Views"
On September 13, 2018, Chairman Clayton issued a "Statement Regarding SEC Staff Views" which emphasized that all statements of the SEC staff are nonbinding and create no enforceable legal rights or obligations of the Commission or other parties. This statement serves as a cautionary note regarding the ability of those offering or dealing in cryptocurrency, among others, to rely upon new or existing relief and guidance.