By Dawn Causey, Andrew Doersam and Thomas Pinder
In 1994, the Today Show posed a question: “What is internet, anyway?” One anchor responded: “internet is that massive computer network. The one that’s becoming really big now.” Another incredulously responded, “what does that mean? What do you like, write to it like mail?”
Much like the internet in 1994, bitcoin and cryptocurrency are mystifying to many people today. The good news is that recent enforcement actions and court decisions are starting to untangle the regulatory and legal complexities surrounding them.
The rapid growth of cryptocurrencies has fueled a surge in initial coin offerings—a form of corporate fundraising that avoids traditional capital markets. Tech startups, primarily from the digital currency sector, create a new virtual coin or token and offer it for public sale. Tokens represent access to company’s product or service, or alternatively can serve as an investment contract for future profits in the form of dividends, revenue share or price appreciation.
Investors and consumers usually access the virtual currency markets through trading platforms. New York has been a leader in establishing regulatory oversight over cryptocurrency markets. In September, the New York attorney general released a report finding that cryptocurrency trading platforms do not adequately take measures to mitigate potential conflicts of interest, impede market manipulation and safeguard the protection of customer funds.
In 2017, ICOs raised more than $4 billion, and in late 2017, both China and Korea banned them. U.S regulators also began scrutinizing ICOs, suggesting that cryptocurrencies may be regulated like securities. The only Supreme Court guidance comes from a 1946 case, SEC v. W.J. Howey Co. This case defined that an “investment contract,” or security for purposes of the securities laws, is an (1) investment of money, (2) in a common enterprise, (3) with an expectation of profit, and (4) dependent solely on the efforts of others. According to the Howey test, if all four elements are satisfied, then the contract or arrangement at issue is a “security.”
In July 2017, the SEC issued a report clarifying that tokens sold in ICOs are securities offerings, and that promoters of ICOs should comply with U.S. securities laws. Most recently, in June 2018, SEC Director William Hinman clarified that a token by itself is not a security, but that offering an ICO in a particular manner may be deemed a securities offering. Hinman emphasized the role of decentralization as a factor in determining whether the asset is no longer subject to federal securities regulation. In other words, if a network has become so decentralized that SEC disclosures would not provide an appreciable benefit to investors, the case for regulation under federal securities laws becomes much less compelling.
On Sept. 20, 2018, a New York federal court handed the SEC a win in U.S. v. Zaslavskiy, finding that two virtual currency or cryptocurrency investment schemes and their related ICOs may be subject to U.S. securities laws. The court pointed out that a reasonable jury would conclude that the defendant promoted investment contracts, or securities, under the Howey test. The court also relied on the SEC’s guidance that cryptocurrencies may be considered securities.
On the same day as the Zaslavskiy decision, FINRA instituted its first cryptocurrency-related disciplinary hearing against a former broker who issued cryptocurrency in exchange for equity ownership in a worthless public company. FINRA alleged that the broker engaged in securities fraud and the illegal distribution of an unregistered cryptocurrency by making fraudulent statements about the nature and value of the underlying company and failing to register the cryptocurrencies.
Regulators continue to scrutinize these new investment vehicles as the courts struggle to apply a 72-year-old Supreme Court test. It is still too early to determine if cryptocurrency is the great disrupter that will eventually replace currency, or if it’s merely an ephemeral investment fad soon to be a regulated afterthought.
Dawn Causey is general counsel at ABA, where Thomas Pinder is SVP for litigation and Andrew Doersam is a paralegal.