Cryptocurrencies and initial coin offerings (ICOs) were a recurring area of focus in presentations by multiple divisions of the Securities and Exchange Commission at its annual “The SEC Speaks” conference in Washington, DC on February 23-24, 2018. While the SEC does not seem to have reached consensus yet on how to treat this new, rapidly evolving and volatile segment of the economy, the panelists were clear that significant caution is warranted and that the Commission will apply existing regulatory requirements where the analogy seems appropriate.
Cryptocurrencies such as Bitcoin, Litecoin, and Ethereum purport to be items of inherent value, akin to cash or gold, that are designed to enable purchases, sales, and other transactions, but lack the backing of any government entity. Proponents of cryptocurrencies claim a number of potential benefits from them, including the ability to make transfers without intermediaries and without geographic limitations, finality of settlement, lower transaction costs, and public verification of transactions. Other characteristics of cryptocurrencies that trigger concerns for some are personal anonymity (or, rather, pseudonymity1) and the purported absence of government regulation or oversight, which can make cryptocurrency an attractive vehicle for money laundering and other illicit activity. That said, individual and institutional investors have been intrigued by reports of, for example, Bitcoin values soaring from $900 to almost $20,000 in one year,2 and currently trading at a somewhat more modest $9,500, hence the interest of the SEC and other government agencies in regulating it.3
The regulators’ remarks at SEC Speaks did not necessarily break new ground—one could read the substance of their concerns in SEC Chair Jay Clayton’s recent public statement on the subject,4 a recent SEC investigative report,5 and a January 2018 Staff Letter.6 However, the repeated attention did reinforce that cryptocurrencies, ICOs, and blockchain technology are receiving cross-disciplinary attention at the SEC.
Division of Corporation Finance
During this panel, William Hinman, Director of the Division of Corporation Finance, noted that digital assets, ICOs and Bitcoin were not even mentioned at last year’s SEC Speaks, but now the Division is “paying a lot of attention to them.” This panel’s remarks focused on the following areas:
Outreach – Because “the technology has a lot of promise,” the Division is focused on a number of outreach efforts to learn about the area “without getting in the way of the technology,” to ensure both that the Division has “the right touch” and that “people do things the right way.”
"Security" – The Division is grappling with defining when a utility token is a “security” subject to SEC regulation.7 Rather than viewing nomenclature as determinative of whether the token is subject to the securities laws, panelists stated that the Commission’s focus would be on the economic substance of what is being offered to investors. David Frederickson, Chief Counsel in the Division of Corporation Finance, stated, “If it’s being sold as an investment for capital returns, the fact that it’s called a ‘token’ doesn’t move our dial.” The panel acknowledged the hybrid nature of this new product, noting: “It’s hard to visualize something being simultaneously a token to buy coffee and an investment in the coffee shop.”
Interplay with Division of Investment Management – The Corporation Finance panel stated that some cryptocurrency products are more retail-oriented and will be “funneled to IM for handling.” The panel noted, however, that Corporation Finance will be applying Investment Management’s January 2018 Staff Letter regarding issues such as fragmentation of the market and custody issues, and therefore forum-shopping between Investment Management and Corporation Finance will not be fruitful.
Division of Investment Management
Dalia Blass, Director of the Division of Investment Management, and Christian Sandoe, Assistant Director in the Division’s Disclosure Review and Accounting Office, led this panel’s discussion on this topic. The panel’s primary focus was on the Staff Letter the Division sent last month to the Investment Company Institute (ICI) and the Securities Industry and Financial Markets Association (SIFMA) seeking to engage in dialogue regarding the “significant investor protection issues that need to be examined before sponsors begin offering [cryptocurrency-related] funds to retail investors.”8 Blass acknowledged that all of the issues identified in the Staff Letter are “antithetical to the system of cryptocurrency” but also fundamental to the concept of the Investment Company Act; that the questions posed by the Staff Letter are not easy questions to answer; and that the Staff hopes that participants in this space will engage in the dialogue. Blass agreed that the Commission’s role is not to engage in “merit regulation,” but stated her belief that the Division has a role to ensure “a good marriage” between the Act and this new set of funds. Blass made clear that the Division will make an effort to find answers to these questions within the framework of the Act.
The questions raised in the January 2018 Staff Letter, and highlighted by the panel at SEC Speaks, included the following:
Valuation – Mutual funds and exchange-traded funds (ETFs) must value their assets each business day in order to strike a net asset value (NAV) which, in turn, drives fund performance and the price paid for these funds. To the extent they are holding cryptocurrencies, how are funds planning to develop and implement policies to “fair value” cryptocurrency-related products in their portfolio, given the volatility and fragmentation of the markets for these products and the current trading volume in cryptocurrency futures markets?
Liquidity – A key feature of mutual funds and ETFs is daily redeemability. Under Rule 22e-4, the new fund liquidity rule, funds must classify their investments into one of four liquidity categories and limit their investments in illiquid securities to 15% of the fund’s assets. How will funds classify cryptocurrencies, and what effect will the volatility in price and trading volume of these products have on fund management?
Custody – The Investment Company Act of 1940 requires that registered funds maintain custody of their holdings. If a fund invests in digital assets that rely upon distributed ledger technology, how will the fund satisfy the requirements of the 1940 Act and related rules? How will the fund validate existence and exclusive ownership, and what effect does the potential for hacks on digital wallets have on the safeguarding of fund assets under the 1940 Act?
Arbitrage (for ETFs) – To promote fair treatment of investors, an ETF is required to have a market price that does not deviate materially from the fund’s NAV. Are ETFs able to assure compliance with this requirement, given the volatility, fragmentation, and trading volume of the cryptocurrency markets?
Manipulation and Other Risks – Cryptocurrency markets feature substantially less investor protection than traditional securities markets, with commensurately greater opportunities for fraud and manipulation. What considerations are these funds giving to these increased risks with cryptocurrencies?
Nomenclature was also a concern for the Investment Management panel. It noted that certain funds are seeking to use “blockchain” in their name to increase investor interest, even when the term does not accurately describe their business or investment strategy. Under the Mutual Fund Names Rule, if a fund’s name suggests a focus on a particular type of investment or industry, at least 80% of the assets should be in that investment or industry.
Division of Enforcement – Cyber Unit
ICOs and digital assets were the first topic of discussion by the panel representing the newly created Cyber Unit of the Division of Enforcement. Robert A. Cohen, Chair of the Cyber Unit, acknowledged the desire to “encourage and facilitate” the use of innovative technology to raise capital in different ways, but remarked that if an ICO is being offered to US investors, it needs to comply with US securities laws regarding registration, fraud, and disclosure. He noted that this is an active area for the regional and home offices of the SEC.
Among the topics highlighted by the Cyber Unit were the following:
"Security" – Like the Division of Corporation Finance, the Cyber Unit is focusing on whether particular digital tokens qualify as securities. Cohen reinforced the message of the Report of Investigation filed in July 2017, also known as the “DAO Report,”9 that digital assets and tokens in many cases are securities. Cohen warned, “Expect more focus in this area, and more substantial remedies, as the industry has been on notice now for quite some time.”
Third Party Advisors – Cohen noted an improving trend towards what he called “real law firms” providing legal opinions regarding whether a particular token is or is not a security, as opposed to an ICO issuer putting forward an internally generated document from a template downloaded off the Internet. He told the audience that funds can anticipate questions from the Commission regarding the analysis they have performed regarding whether the product should be considered a security.
Enforcement Activity – In response to questioning, Cohen referred to an October 2017 speech by Stephanie Avakian, Co-Director of the Division of Enforcement,10 and stated that although no enforcement cases have yet been brought in this area, the Division of Enforcement is mindful that there could be violations and will bring cases if appropriate. “We are not trying to second-guess reasonable, good faith decisions,” Cohen said.
Office of the Chief Accountant
To a greater degree than the previous panels, the Office of the Chief Accountant (OCA) panel encouraged engagement on this issue by accounting firms and other participants. Led by newly appointed Chief Accountant Kyle Moffatt, the cryptocurrency-related issues highlighted by this panel included the following:
Custody – The panel echoed the Division of Investment Management’s concern regarding how a fund would validate existence and exclusive ownership of cryptocurrency-related products.
Valuation – The panel reiterated the concerns expressed by prior panels regarding whether funds holding cryptocurrencies have sufficient information to value these assets, given the significant volatility, fragmentation and low volume of trades in this market. The panel also asked how a fund would handle receipt of a distribution resulting from a hard fork.11 The timing of event recognition would need to be considered, as well as tax and other regulatory impacts.
Concluding that “compliance is both possible and required,” the OCA panel stated that it is available for consultation as needed.
Cryptocurrencies received little if any attention at SEC Speaks 2017, but it is clear that they are front and center for the Commission in 2018. Chair Clayton stated in his opening remarks at the conference that the SEC “must be nimble and forward-looking.” While the panels presented more questions than answers, all were intent on approaching this rapidly evolving market with both care and all deliberate speed. Companies issuing or investing in cryptocurrency, as well as broker-dealers, law firms and accounting firms, are all on notice that the SEC is watching, and they should govern themselves accordingly.
1 Cryptocurrencies are often described as anonymous currencies because it is possible to send and receive them without giving any personally identifying information. A more technically accurate term, however, would be “pseudonymous.” The address at which one receives Bitcoin, for example, is one’s pseudonym, and if that address is linked to one’s identity, transactions to or from that address will not be anonymous.
2 “From $900 to $20,000: Bitcoin’s Historic 2017 Price Run Revisited” (Dec. 29, 2017), available at https://www.coindesk.com/900-20000-bitcoins-historic-2017-price-run-revisited/.
3 The SEC takes the position that it regulates all securities offered to US investors, including cryptocurrencies that double as investment vehicles. The Commodity Futures Trading Commission (CFTC) determined in 2015 that Bitcoin qualifies as a “commodity” that it can monitor under federal law. And the Internal Revenue Service considers cryptocurrencies such as Bitcoin to be property for federal tax purposes, meaning that any profits or losses from the sale or exchange of the virtual coins should generally be reported as capital gains or losses.
4 Chair Jay Clayton, Statement on Cryptocurrencies and Initial Coin Offerings (Dec. 11, 2017), available at https://www.sec.gov/news/public-statement/statement-clayton-2017-12-11.
5 Report of Investigation Pursuant to Section 21(a) of the Securities Exchange Act of 1934: The DAO, SEC Rel. No. 81207 (July 25, 2017), available at https://www.sec.gov/litigation/investreport/34-81207.pdf.
6 Staff Letter: Engaging on Fund Innovation and Cryptocurrency-Related Holdings (Jan. 18, 2018), available at https://www.sec.gov/divisions/investment/noaction/2018/cryptocurrency-011818.htm.
7 Two common types of coins offered in ICOs are equity tokens and utility tokens. Equity tokens, as the name would imply, are a category of security tokens that represent ownership of an asset, such as debt or company stock; the SEC has taken the position that equity tokens are subject to SEC regulation. Utility tokens provide users with future access to a product or service and, although they can fluctuate in value, they do not provide holders with an ownership stake in a company’s platform or another asset.
8 Staff Letter: Engaging on Fund Innovation and Cryptocurrency-Related Holdings (Jan. 18, 2018), available at https://www.sec.gov/divisions/investment/noaction/2018/cryptocurrency-011818.htm.
9 Report of Investigation Pursuant to Section 21(a) of the Securities Exchange Act of 1934: The DAO, SEC Rel. No. 81207 (July 25, 2017), available at https://www.sec.gov/litigation/investreport/34-81207.pdf.
10 Stephanie Avakian, “The SEC Enforcement Division’s Initiatives Regarding Retail Investor Protection and Cybersecurity” (Oct. 26, 2017), available at https://www.sec.gov/news/speech/speech-avakian-2017-10-26.
11 A “hard fork,” in blockchain terminology, is a permanent break in the chain of transactions to, for example, correct security risks, add new functionality, or reverse transactions due to hacking.