A startling trend has recently emerged in the cryptocurrency industry. Since July 2017, the U.S. Securities and Exchange Commission (SEC) has regularly begun asserting itself in this space. It has taken various actions against several companies relating to their Initial Coin Offerings, or “ICOs,” or other cryptocurrency activities. It investigated The DAO, an online corporation, and declared that its ICO involved securities subject to regulation under federal securities laws. It also suspended trading in the stock of four other companies due to concerns over the accuracy of public information relating to their cryptocurrency activities. What does this trend mean for the industry? Looking more closely at the SEC’s actions, the answer is: to be vigilant but not paranoid.
The DAO Legacy
Federal securities laws generally require that instruments constituting “securities” are registered with the SEC in order to protect investors by ensuring public access to key information needed for making an informed investment decision. On July 25, 2017, the SEC issued a Report of Investigation on The DAO, concluding that DAO Tokens sold in its ICO were “investment contracts” and therefore securities that should have been registered.
The DAO (short for Decentralized Autonomous Organization) sold over one billion DAO Tokens in exchange for ether. The proceeds were to be used to fund various “projects” once they were vetted and approved by Curators, who were selected by The DAO’s founders. DAO Token holders could vote on which projects to fund, and profits from those projects would be distributed among Token holders.
Applying the Howey test (named for the Supreme Court case that announced it), which says that something is an investment contract if it involves (1) an investment of money (2) in a common enterprise (3) with a reasonable expectation of profits derived from the managerial efforts of others, the SEC found that DAO Tokens were securities because:
- Purchasing DAO Tokens in exchange for ether constituted an “investment of money”;
- A “common enterprise” existed because the ether was pooled and used to fund projects aimed at making profits, which would be distributed to DAO Token holders; and
- DAO Token holders expected these profits from the efforts of The DAO founders and Curators, who, among other things, created and monitored The DAO and vetted potential projects. While Token holders could vote on which projects to fund, they were still essentially relying on others, because they could vote only after projects had been curated.
Although these findings applied only to The DAO, the SEC noted that it wanted “to stress that the U.S. federal securities law may apply to various activities, including distributed ledger technology, depending on the particular facts and circumstances, without regard to the form of the organization or technology used to effectuate a particular offer or sale.” This declaration undoubtedly foreshadows continued investigations and enforcement actions relating to ICOs.
Federal law authorizes the SEC to suspend trading in a company’s stock summarily for up to 10 business days when needed to protect investors or in the public interest. In a recent Investor Alert, the SEC explained that such suspensions may result from a “lack of current, accurate, or adequate information about the company”; “questions about the accuracy of publicly available information” concerning the company’s “operational status and financial condition”; or “questions about trading in the stock.” In the cryptocurrency context, the SEC is especially concerned about scams in which companies “publicly announc[e] ICO or coin/token related events to affect the price of the company’s common stock.” It warned specifically about two red flags signaling possible “ICO-related fraud”: companies whose stock is trading that (1) claim without explanation that their ICO is “SEC-compliant” or (2) “purport to raise capital through an ICO or take on ICO-related business described in vague or nonsensical terms or using undefined technical or legal jargon.”
In August 2017, the SEC issued 10-day suspension orders in shares of four companies due to concerns relating to public statements about their cryptocurrency activities and ICOs. First, on August 3, the SEC suspended trading in shares of Strategic Global Investments, Inc., over questions regarding the accuracy of statements in certain press releases relating to “the activities of the company with respect to [ICOs].” Each of the cited press releases touted generally that the company planned to sponsor “SEC compliant ICOs.”
Next, on August 9, the SEC issued a temporary trading ban in shares of CIAO Group (recently renamed as NuMelo Technology) due to questions regarding the accuracy of various public statements relating to certain business plans and a planned ICO. The cited press releases, including those from March 16, June 15 and July 6, contained vague statements that CIAO planned to invest in telecommunications projects in emerging markets and to facilitate the provision of financial services to developing nations through blockchain technology, including through an ICO.
On August 23, the SEC suspended trading in shares of First Bitcoin Capital Corp., a company involved in developing digital currencies and other blockchain technology, due to “concerns regarding the accuracy and adequacy of publicly available information about the company including, among other things, the value of [its] assets and its capital structure.”
Finally, on August 24, the SEC issued a suspension order against American Security Resources Corp. (renamed to Bitcoin Crypto Currency Exchange Corp.) due to statements in press releases “concerning, among other things, the company’s business transition to the cryptocurrency markets and early adoption of blockchain technology.” These press releases from August 1 and August 8 announced vaguely that the company was “enter[ing] the booming Crypto currency markets,” developing a mobile cryptocurrency trading application and acquiring a company that had created “a smartphone-based payment and money transfer system.”
The SEC’s suspension orders did not specify the language or facts triggering its action, but each of these companies appears to have strayed into the red-flag territory the SEC has identified. Its oversight in this area will thus likely continue and be directed at preventing fraud and improving disclosures to investors on new or not-well-understood technologies.
Implications for the Cryptocurrency Industry
This recent flurry of SEC activity should be taken seriously by the cryptocurrency industry because it is only the start. The SEC will continue to monitor businesses involved with cryptocurrencies. Companies considering engaging in ICOs should therefore carefully consider and seek legal advice regarding whether their tokens possess characteristics that might make them resemble securities. They should also consult counsel when preparing public statements relating to their cryptocurrency activities or assets.
Anyone predicting the beginning-of-the-end for the industry based on these events, however, is overreacting. As more businesses become engaged in cryptocurrency-related activities, more people will buy tokens or invest in companies innovating within the cryptocurrency space, which ignites regulators’ investor-protection instincts. While the SEC has bared its teeth where it perceived a threat to investors, it has not demonstrated aggression toward the industry as a whole. Indeed, the SEC was careful not to say that ICOs categorically involve securities; it cautioned only that whether a token is a security depends on the “facts and circumstances” of each case. That the SEC is watching the cryptocurrency industry is thus a symptom of the industry’s success, not a sign of its demise.
This is a guest post by Jeffrey Alberts and Yvonne Saadi of Pryor Cashman's Financial Institutions Group. Opinions expressed are their own and do not necessarily reflect those of BTC Media or Bitcoin Magazine.