By Michael W. Ross and Andrew J. Lichtman
September saw a flurry of activity that will help further define the cryptocurrency regulatory landscape. The Financial Industry Regulatory Authority (“FINRA”) brought its first-ever crypto-fraud case and a court ruling by the U.S. District Court for the Eastern District of New York gave backing to the view that digital assets will be viewed as securities. And, in two enforcements actions, the U.S. Securities and Exchange Commission (“SEC”) branched out beyond actions against fraudulent crypto-schemes and went after crypto companies for failing to register with the SEC. The latter two cases signal that the SEC is committed to enforcing applicable securities law requirements beyondthose accused of fraud, and therefore SEC enforcement activity remains an area for legitimate businesses to watch.
A Federal Court Rules On Whether Digital Assets Are Securities
Last October, the U.S. Attorney’s Office in Brooklyn brought charges against Maksim Zaslavskiy alleging that Zaslavskiy made false representations in connection with two cryptocurrencies and their related initial coin offerings (“ICOs”) in violation of U.S. securities law. According to the indictment, Zaslavskiy induced investors to purchase tokens in an ICO for “REcoin” by falsely claiming that REcoin was backed by real estate investments. Similarly, the government alleged, Zaslavskiy falsely claimed that a second cryptocurrency, “Diamond,” was backed by actual diamonds when it was not.
Zaslavskiy moved to dismiss the indictment arguing that the REcoin and Diamond offerings did not involve securities under the Supreme Court’s Howey test. In a seminal ruling on the issue, the court rejected Zaslavskiy’s argument and found that a reasonable jury could conclude that the cryptocurrency transactions were “investment contracts.” Applying the federal securities laws “flexibly,” the court held that a reasonable jury could conclude that: (1) defrauded individuals invested money (2) in a common enterprise and (3) were led to expect that profits from the REcoin and Diamond enterprise would be derived solely from the managerial efforts of Zaslavaskiy. The decision was consistent with recent remarks by William Hinman, the SEC’s Director of the Division of Corporate Finance, with regard to determining whether digital assets are securities.
FINRA Brings a Fraud Action Involving Cryptocurrency
On September 11, 2018, FINRA filed an action against Timothy Tilton Ayre in its “first disciplinary action involving cryptocurrencies.” In its complaint, FINRA alleged that Ayre purchased the rights to a cryptocurrency called HempCoin and repackaged it into a security backed by the stock of Rocky Mountain Ayre, a worthless company Ayre owned. Ayre then marketed HempCoin as “the world’s first currency to represent equity ownership” in a publicly-traded company. FINRA alleges that Ayre defrauded investors by making false statements about Rocky Mountain’s business and failing to register HempCoin as a security.
SEC Extends Enforcement Activity Into Registration Violations
This month also witnessed the expansion of the types of enforcement actions by the SEC, with two actions against crypto companies for failing to register. In one case—In re TokenLot—the SEC brought its first case charging that a company selling digital tokens was an unregistered broker-dealer. According to the SEC’s settlement order, TokenLot, which was a self-described “ICO Superstore,” was promoted as a way to purchase digital tokens during ICOs and also to engage in secondary trading. By soliciting investors and facilitating the sales of digital tokens, TokenLot and its two founders were required to register with the SEC as broker-dealers, but they failed to do so.
In the other case—In re Crypto Asset Management—the SEC brought an enforcement action claiming that a hedge fund manager that invested in digital assets failed to register as an investment company. According to the SEC’s order, the fund raised $3.6 million by marketing itself as the “first regulated crypto asset fund in the United States.” But it had failed to file a registration statement and therefore was operating as an unregistered investment company.
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These cases further cement the view that regulators, and now courts, will continue to treat certain digital assets as securities, with all the attendant securities law requirements. As the SEC actions show, that will mean more than just enforcement actions against those using the new technology to defraud the unwitting. It will also mean that other players in the space—such as those acting as brokers and asset managers—will need to take steps to assure themselves that they are abiding by relevant securities law provisions, lest they invite an enforcement action.