Background on the Development of Securities Tokens
Securities token standards and platforms are currently being developed to permit companies to issue tokenized securities that are compliant with U.S. federal and state securities laws. Startups that are engaged in the development of securities token software include: Abacus, AlphaPoint, Arca, Harbor, OpenFinance, Polymath, Securitize, Swarm, Templum, Tokensoft, Tokeny, tZERO, and Vertalo.
There are currently several different standards that are being developed for security tokens. These standards include DS (Securitize), ERC-1404 (Tokensoft), Ravencoin (Ravencoin), R-Token (Harbor), ST-20 (Polymath), and S3 (OpenFinance). These securities tokens are being developed with more functionality than generic ERC-20 tokens.
Companies are also offering internet platforms and software for the issuance of non-tokenized securities under the SEC Rule 506(c) and Regulation Crowdfunding exemptions. These internet platforms include SeedInvest and StartEngine. Companies can also can utilize software, such as Carta, to manage their cap tables. The startup, Liquifi, is engaged in the development of software that will permit companies to both manage their cap tables and provide for liquidity to their stockholders.
Several startups — such as OpenFinance and tZERO – have launched SEC-registered alternative trading systems (“ATS”) to permit the trading of securities tokens in compliance with U.S. securities laws. An ATS is a trading system that meets the definition of “exchange” under federal securities laws, but is not required to register as a national securities exchange, pursuant to the exemption provided under Rule 3a1-1(a)(2) of the Securities Exchange Act. To operate under this exemption, an ATS must (i) register as a broker-dealer, (ii) file an initial operation report with the SEC on Form ATS prior to commencing operations, (iii) comply with FINRA reporting requirements, and (iv) comply with the additional requirements of SEC Regulation ATS. A list of registered ATS exchanges is set forth on this SEC website.
In addition, several startups have acquired or formed broker-dealer affiliates that are licensed with the SEC and FINRA. These include Coinbase (which acquired Keystone Capital Corporation), Circle (which acquired SI Securities, LLC and its affiliate, SeedInvest), Harbor (which formed Harbor Square Investments), StartEngine (which formed StartEngine Primary LLC to facilitate Regulation A offerings), and Chainstone Labs (which formed Watchdog Capital LLC).
Arca U.S. Treasury, a closed-end mutual fund that intends to issue its shares in the form of ERC-20 securities tokens, has filed a Form N-2 preliminary prospectus for the approval of the SEC. Investors would be able to purchase the mutual fund’s shares with iOS and Android wallet apps. Holders of the securities tokens would be able to use their mobile phone wallets to send and receive the Fund’s shares in peer-to-peer transactions without the use of a central clearing agency.
On October 28, 2019, Paxos Trust Company, LLC, a New York non-depository trust company, received a no-action letter from the SEC that permits it to test a blockchain-based securities settlement and clearance service for listed U.S. equity securities trades. Paxos Settlement Service will initially conduct a limited number of securities settlement transactions for Credit Suisse and Société Générale. On February 20, 2020, Paxos announced that Paxos Settlement Service can now settle certain U.S. listed equity trades between broker-dealers Credit Suisse and Instinet, LLC through the utilization of blockchain technology.
SEC Classifies Certain Tokens as Securities
The Securities and Exchange Commission (the “SEC”) has regulatory authority over the issuance or resale of any ethereum token or other digital asset that has the characteristics of an “investment contract”. Under Securities Act § 2(a)(1) and Securities Exchange Act § 3(a)(10), a security includes “an investment contract.” See 15 U.S.C. §§ 77b-77c. An “investment contract” has been defined by the U.S. Supreme Court as an investment of money in a common enterprise with a reasonable expectation of profits to be derived from the entrepreneurial or managerial efforts of others. See SEC v. W.J. Howey Co., 328 U.S. 293, 301 (1946); SEC v. Edwards, 540 U.S. 389, 393 (2004).
In making a determination as to whether a digital asset is an “investment contract,” both the SEC and the courts look at the substance of the transaction, instead of its form. In 1943, the U.S. Supreme Court determined that “the reach of the [Securities] Act does not stop with the obvious and commonplace. Novel, uncommon, or irregular devices, whatever they appear to be, are also reached if it be proved as matter of fact that they were widely offered or dealt in under terms or courses of dealing which established their character in commerce as ‘investment contracts,’ or as ‘any interest or instrument commonly known as a ‘security’.” SEC v. C.M. Joiner Leasing Corp., 320 U.S. 344, 351 (1943); see also Tcherepnin v. Knight, 389 U.S. 332 (1967); United Housing Found., Inc. v. Forman, 421 U.S. 837 (1975). In 1990, the U.S. Supreme Court determined that “Congress’ purpose in enacting the securities laws was to regulate investments, in whatever form they are made and by whatever name they are called.” Reves v. Ernst & Young, 494 U.S. 56, 61 (1990).
On April 3, 2019, the SEC published the Framework for “Investment Contract” Analysis of Digital Assets, which provides a checklist for analyzing whether a digital asset is being sold as an investment contract. If the digital asset is an investment contract, it will be subject to the complex sale requirements and restrictions that are set forth in federal securities laws.
On April 3, 2019, the SEC issued a no-action letter to TurnKey Jet, Inc., (“TJK“) that set forth the view of the SEC’s Division of Corporate Finance that utility tokens that are issued to customers to purchase TJK’s jet charter services are not securities. The SEC no-action letter stated that the SEC’s position was based upon the following facts:
“TKJ will not use any funds from Token sales to develop the TKJ Platform, Network, or App, and each of these will be fully developed and operational at the time any Tokens are sold; the Tokens will be immediately usable for their intended functionality (purchasing air charter services) at the time they are sold; TKJ will restrict transfers of Tokens to TKJ Wallets only, and not to wallets external to the Platform; TKJ will sell Tokens at a price of one USD per Token throughout the life of the Program, and each Token will represent a TKJ obligation to supply air charter services at a value of one USD per Token; If TKJ offers to repurchase Tokens, it will only do so at a discount to the face value of the Tokens (one USD per Token) that the holder seeks to resell to TKJ, unless a court within the United States orders TKJ to liquidate the Tokens; and The Token is marketed in a manner that emphasizes the functionality of the Token, and not the potential for the increase in the market value of the Token.”
On July 25, 2019, the SEC issued a no-action letter to Pocketful of Quarters, Inc., (“PoQ”) that set forth the view of the SEC’s Division of Corporate Finance that utility tokens that are issued by POQ to persons seeking to play online video games are not securities.
On November 19, 2020, the SEC issued a no-action letter to IMVU, Inc. (“IMVU”) that set forth the view of the SEC’s Division of Corporate Finance that “VCOIN” tokens that are sold at a fixed price of $0.004 a coin by IMVU to persons using certain online avatar-based virtual world platforms are not securities.
The Chairman of the SEC has previously taken the position that even if a token issued in an initial coin offering (“ICO”) has “utility,” the token can be still be deemed to be a security that is regulated under the Securities Act. On February 6, 2018, in written testimony to the U.S. Senate Banking Committee, the Chairman of the SEC stated as follows:
“Certain market professionals have attempted to highlight the utility or voucher-like characteristics of their proposed ICOs in an effort to claim that their proposed tokens or coins are not securities. Many of these assertions that the federal securities laws do not apply to a particular ICO appear to elevate form over substance. The rise of these form-based arguments is a disturbing trend that deprives investors of mandatory protections that clearly are required as a result of the structure of the transaction. Merely calling a token a ‘utility’ token or structuring it to provide some utility does not prevent the token from being a security. Tokens and offerings that incorporate features and marketing efforts that emphasize the potential for profits based on the entrepreneurial or managerial efforts of others continue to contain the hallmarks of a security under U.S. law. It is especially troubling when the promoters of these offerings emphasize the secondary market trading potential of these tokens, i.e., the ability to sell them on an exchange at a profit. In short, prospective purchasers are being sold on the potential for tokens to increase in value – with the ability to lock in those increases by reselling the tokens on a secondary market – or to otherwise profit from the tokens based on the efforts of others. These are key hallmarks of a security and a securities offering.”‘
On September 11, 2018, the U.S. District Court for the Eastern District of New York held that a digital token can be deemed to be a security under the Howey test. See U.S. v. Zaslavskiy, No.17- CR-647(RJD) (E.D.N.Y. September 11, 2018).
If an ethereum token or other digital asset is a security (because it is an “investment contract”), then the issuer must issue the security by means of either a registered securities offering or an exemption from securities registration requirements. The definition of issuer is broadly defined to include “every person who issues or proposes to issue any security” and “person” includes “any unincorporated organization.” 15 U.S.C. § 77b(a)(4).
Federal Offering Exemptions for Securities Tokens
At this time, there are three federal securities offering exemptions that are, at this time, the most useful for a securities token offering (“STO”) in the United States. These exemptions are: (i) the Rule 506(c) offering exemption (which requires the preparation of a private placement memorandum that is not filed with the SEC), (ii) the Regulation Crowdfunding offering exemption (which requires the preparation of an offering statement that is filed with the SEC), and (iii) the Regulation A “Conditional Small Issues Exemption” (which requires the preparation of an offering circular that is subject to the prior review and qualification by the SEC).
On July 10, 2019, the SEC qualified the first blockchain-based Regulation A, Tier 2, non-equity securities token offering. Examples of qualified securities token offerings include: (i) Stack Tokens (distributed on the proprietary Stacks blockchain) issued by Blockstack PBC, a Delaware public benefit corporation (qualified by the SEC on July 10, 2019) and (ii) Props Tokens (distributed on the ethereum blockchain) issued by YouNow, Inc., a Delaware corporation (qualified by the SEC on July 11, 2019).
For issuers that do not want to go through a more expensive Regulation A qualification process, the SEC permits a company to sell securities through a “side-by-side” or “concurrent” offering structure. The issuer can make two separate and simultaneous general solicitations of securities to the public: (i) a Rule 506(c) offering for an unlimited maximum dollar amount of securities to accredited investors and (ii) a Regulation Crowdfunding offering of up to $1,070,000 in securities (restricted to non-accredited investors).
Certain Federal Offering Exemptions Useful to Startups and Businesses
Set forth below are the summaries of certain federal securities offering exemptions that can be useful to startups and businesses who are conducting a securities offering in the United States. It should be noted that the SEC Rule 506(b), Rule 504 and Rule 506(c) exemptions differentiate between “accredited” and “non-accredited” investors. An individual investor is an “accredited investor” only if he or she (i) is a director or executive officer of the corporation issuing the securities, (ii) has an individual net worth (or joint net worth with a spouse) that exceeds $1 million, excluding the value of the investor’s primary residence, (iii) has an individual income that exceeds $200,000 in each of the two most recent years, and has a reasonable expectation of reaching the same individual income level in the current year, or (iv) has a joint income that exceeds $300,000 in each of the two most recent years, and has a reasonable expectation of reaching the same joint income level in the current year. See SEC Rule 501(a)(5) (17 C.F.R. § 230.501(a)(5)).
Unlike the other exemptions set forth below, the Regulation A “Conditional Small Issues Exemption” requires that the offering circular be subject to the prior review and qualification by the SEC. The Regulation A exemption (17 C.F.R. § 230.251) has the primary advantage of permitting non-affiliate purchasers to resell their securities immediately. As Regulation A securities are not “restricted securities,” non-affiliates of the issuing company are not subject to the transferability restrictions set forth under Rule 144 (17 C.F.R. § 230.144).
It should be noted that federal exemptions from securities registration requirements for equity securities are generally unavailable to a company that has (i) more than $10,000,000 in assets and has (iI) 2,000 or more equity security holders or 500 or more non-accredited equity security holders. See Section 12(g) of the Securities Exchange Act (15 U.S.C. §78l(g). The SEC defines “equity security” as follows: ‘The term equity security is hereby defined to include any stock or similar security, certificate of interest or participation in any profit sharing agreement, preorganization certificate or subscription, transferable share, voting trust certificate or certificate of deposit for an equity security, limited partnership interest, interest in a joint venture, or certificate of interest in a business trust; any security future on any such security; or any security convertible, with or without consideration into such a security, or carrying any warrant or right to subscribe to or purchase such a security; or any such warrant or right; or any put, call, straddle, or other option or privilege of buying such a security from or selling such a security to another without being bound to do so.” See 17 C.F.R. § 240.3a11-1.
|Type||Summary of Federal Securities Offering Exemption||Who May Invest|
|Section 4(a)(2)||No limit on total amount of securities sold. No filings required with the SEC. State securities offering exemption requirements apply. Customarily utilized at the time of incorporation of a startup for the initial stock issuance to a small group of founders who are the initial directors and officers of the company. State securities offering exemption requirements apply.||Small Group of Founders (no general solicitation)|
|Rule 506(b) (limited to accredited investors)||No limit on total amount of securities sold. Form D filed with the SEC. Potential investors receive information through a Private Placement Memorandum that is not filed with or qualified by the SEC. Preemption of state securities offering exemption requirements.||Accredited Investors Only (no general solicitation)|
|Rule 504 (with no state securities registration)||$10,000,000 limit on total amount of securities sold in a 12 month period. Form D filed with the SEC. Potential investors receive information through a Private Placement Memorandum that is not filed with or qualified by the SEC. State securities offering exemption requirements apply.||All Investors (no general solicitation)|
|Rule 506(c)||No limit on total amount of securities sold. Form D filed with the SEC. Potential investors receive information through a Private Placement Memorandum that is not filed with or qualified by the SEC. Verification of accredited investor status required. Preemption of state securities offering exemption requirements.||Accredited Investors Only (general solicitation to public)|
|Regulation Crowdfunding||$5,000,000 limit on total amount of securities sold in a 12 month period. Form C filed with the SEC. Potential investors receive information through an offering statement that is publicly filed with the SEC, but has not been qualified by the SEC. Investment by each investor is limited as follows: (i) if either annual income or net worth is less than $107,000, investment is limited to the greater of either $2,200 or 5% of the lesser of annual income or net worth and (ii) if both annual income and net worth are equal to or more than $107,000, investment is limited to 10% of annual income or net worth, whichever is lesser, but no more than $107,000. Preemption of state securities offering exemption requirements. Company must periodically file financial information with the SEC (subject to certain exemptions for smaller companies).||All Investors (general solicitation to public)|
|Regulation A, Tier 2||$75,000,000 limit on total amount of securities sold in a 12 month period. Form 1-A filed with the SEC. Potential investors receive information through an offering circular that is filed with the SEC, and has been qualified by the SEC. Investment by non-accredited investors limited to 10% of annual income or net worth. Preemption of state securities offering exemption requirements. Company must periodically file financial information with the SEC.||All Investors (general solicitation to public)|
Resale Restrictions for Securities Purchased In Private Offerings
Securities purchased in a private securities offering have the disadvantage of being subject to certain complex resale restrictions. These restrictions tend to significantly reduce the liquidity of privately held shares and make it more difficult to develop compliant securities tokens.
Affiliates of issuers of securities are subject to certain additional resale restrictions for control securities that are set forth in SEC Rule 144(b)(2). An “affiliate” of an issuer has been ambiguously defined by the SEC as “a person that directly, or indirectly through one or more intermediaries, controls, or is controlled by, or is under common control with such issuer.” See 12 C.F.R. § 230.144(a)(1). SEC Rule 405 defines “control” as “the possession, direct, or indirect, of the power to direct or cause the direction of the management and policies of a person, whether through the ownership of voting securities, by contract or otherwise.” 12 C.F.R. § 230.405. The SEC has stated that an individual’s “status as an officer, director or 10% shareholder is one fact which must be taken into consideration” in determining affiliate status. See American Standard, SEC No Action Letter Fed. Sec. L. Rep. ¶ 79,071 (Oct. 11, 1972).
Affiliates and non-affiliates of a non-reporting company can generally resell securities that they purchased in a Section 4(a)(2) or Regulation D private placement under certain resale exemptions, which include those set forth in the chart below:
|Exemption||Non-Affiliate Resale||Affiliate Resale|
|Rule 144||A non-affiliate stockholder is generally permitted under SEC Rule 144(b)(1) to conduct a private or a public resale of securities to both accredited and non-accredited investors, if the stockholder has held the shares for at least one year.||An affiliate stockholder is generally permitted under SEC Rule 144(b)(2) to conduct a private or a public resale of securities to both accredited and non-accredited investors, if the stockholder has held the shares for at least one year, and the following additional requirements are met: (i) the company makes publicly available certain specified information on a quarterly basis, (ii) the amount sold by the affiliate does not exceed 1% of the outstanding shares during a three month period, (iii) the sales must be handled as routine brokerage transactions, and (iv) a notice is filed with the SEC on Form 144, if the sale involves more than 5,000 shares or the aggregate dollar amount is greater than $50,000 in any three month period.|
|Section 4(a)(7)||A non-affiliate stockholder is generally permitted under Section 4(a)(7) of the Securities Act to privately resell their securities to accredited investors, if (i) the class of securities has been authorized or outstanding for at least 90 days, (ii) no general solicitation or advertising is done, (iii) certain specified information is provided to the purchaser (including balance sheet and profit and loss statements for the preceding two years), and (iv) the seller complies with certain other restrictions and requirements.||An affiliate stockholder is generally permitted under Section 4(a)(7) of the Securities Act to privately resell their securities to accredited investors, if (i) the class of securities has been authorized or outstanding for at least 90 days, (ii) no general solicitation or advertising is done, (iii) certain specified information is provided to the purchaser (including balance sheet and profit and loss statements for the preceding two years), and (iv) the seller complies with certain other restrictions and requirements.|
|Rule 144A||A non-affiliate stockholder is generally permitted under SEC Rule 144A to conduct a resale of securities to a qualified institutional buyer (“QIB”), through a general solicitation and without a minimum holding period. A QIB includes (i) certain types of financial institutions (such as insurance companies, small business investment companies, business development companies, 501(c)(3) charitable organizations, employee benefit plans, investment companies, registered investment advisors and banks) that, in the aggregate, own and invest on a discretionary basis at least $100 million in securities of unaffiliated issuers and (ii) a registered broker-dealer that owns and invests on a discretionary basis at least $10 million in securities of unaffiliated issuers.||An affiliate stockholder is generally permitted under SEC Rule 144A to conduct a resale of securities to a qualified institutional buyer (“QIB”), through a general solicitation and without a minimum holding period.|
Potential Liability of Company and its Directors
In a private securities offering, the private placement memorandum and subscription agreement must be carefully prepared in order to reduce the potential liability that the securities offering will bring to the company, its directors, and its executive officers. If a securities offering has not been properly registered or exempted under applicable securities laws, a purchaser of securities can, subject to certain restrictions, file a lawsuit against the corporation to seek the rescission of his or her purchase. A purchaser of securities can, subject to certain restrictions, file a lawsuit against the company and its directors and executive officers for damages caused by an untrue statement of a material fact or an omission of a material fact that was made in the offering. There is other potential liability, including criminal penalties for willful violations of securities law.
Several class action lawsuits have been filed against companies that have conducted initial coin offerings that offered ethereum tokens to United States citizens. Copies of the complaints of some of these lawsuits are set forth below.
|Date||Private Securities Litigation Lawsuit|
|11/13/2017||Tezos ICO – Class Action Complaint in U.S. District Court M.D. Florida|
|11/26/2017||Tezos ICO – Class Action Complaint in U.S. District Court N.D. California|
|12/13/2017||Tezos ICO – Class Action Complaint in the U.S. District Court N.D. California|
|12/13/2017||Centra ICO – Class Action Complaint in the U.S. District Court S.D. Florida|
|12/21/2017||ATB ICO – Class Action Complaint in the U.S. District Court S.D. New York|
|12/28/2017||Giga Watt ICO – Class Action Complaint in the U.S. District Court E.D. Washington|
|01/24/2018||Bitconnect – Class Action Complaint in the U.S. District Court S.D. Florida|
|01/29/2018||Bitconnect – Complaint in the U.S. District Court W.D. Kentucky|
|01/30/2018||Bitconnect – U.S. District Court W.D. Kentucky – Temporary Restraining Order|
|05/03/2018||Ripple Labs, Inc. XRP Sales – Class Action Complaint in the California Superior Court|
SEC Investor Alerts and Bulletins
On October 18, 2018, the SEC created a web page dedicated to securities tokens and SEC fintech regulation: sec.gov/finhub. The SEC FinHub website also permits you to contact the SEC with your questions “relating to FinTech issues arising under the federal securities laws” using their email form: SEC FinHub Contact Form.
Since July 23, 2013, the SEC has issued a series of investor alerts and bulletins with respect to ponzi schemes using cryptocurrencies, bitcoin investments, ethereum tokens and ICOs. The SEC’s alerts and bulletins include the following:
|07/23/2013||SEC Investor Alert – Ponzi Schemes Using Virtual Currencies|
|05/07/2014||SEC Investor Alert – Bitcoin and Virtual Currency-Related Investments|
|07/25/2017||SEC Investor Bulletin – Initial Coin Offerings|
|07/25/2017||SEC Report of Investigation – Slock.it UG Decentralized Autonomous Organization Blockchain Tokens|
|08/28/2017||SEC Investor Alert – Public Companies Making ICO-Related Claims|
|11/01/2017||SEC Public Statement – Statement on Potentially Unlawful Promotion of Initial Coin Offerings and Other Investments by Celebrities and Others|
|12/11/2017||SEC Public Statement – Statement on Cryptocurrencies and Initial Coin Offerings|
|01/22/2018||SEC Chairman’s Speech – Expectations for Attorneys and Other Professionals in Initial Coin Offerings|
|03/07/2018||SEC Public Statement – Potentially Unlawful Online Platforms for Trading Digital Assets|
|05/18/2018||SEC Public Statement – Howeycoins Example of Fraudulent ICO||WEB|
|11/16/2018||SEC Public Statement – Digital Asset Securities Issuance and Trading|
|04/03/2019||SEC Framework for “Investment Contract” Analysis of Digital Assets|
|07/08/2019||SEC/FINRA Joint Staff Statement on Broker-Dealer Custody of Digital Asset Securities|
|10/11/2019||SEC CFTC FinCEN Joint Statement on Activities Involving Digital Assets|
|01/14/2020||SEC Investor Alert – Initial Exchange Offerings (IEOs)|
Alternative Trading Systems for Securities Tokens
Securities broker-dealers and exchanges are subject to (i) the regulatory and enforcement authority of the SEC and (ii) the licensing, examination and enforcement authority of the Financial Industry Regulatory Authority (“FINRA”). FINRA is a private, non-profit corporation that acts as a self-regulatory organization for securities broker-dealers.
On March 7, 2018, the SEC provided the following guidance: “If a platform offers trading of digital assets that are securities and operates as an ‘exchange,’ as defined by the federal securities laws, then the platform must register with the SEC as a national securities exchange or be exempt from registration.” SEC Public Statement, Potentially Unlawful Online Platforms for Trading Digital Assets (March 7, 2018). The SEC further stated that “investors should use a platform or entity registered with the SEC, such as a national securities exchange, alternative trading system (“ATS”), or broker-dealer.”
An ATS is a trading system that meets the definition of “exchange” under federal securities laws, but is not required to register as a national securities exchange, pursuant to the exemption provided under Rule 3a1-1(a)(2) of the Securities Exchange Act. To operate under this exemption, an ATS must (i) register as a broker-dealer, (ii) file an initial operation report with the SEC on Form ATS prior to commencing operations, (iii) comply with FINRA reporting requirements, and (iv) comply with the additional requirements of SEC Regulation ATS. A list of registered ATS exchanges is set forth on this SEC website.
On July 6, 2018, FINRA published Regulatory Notice 18-20, FINRA Encourages Firms to Notify FINRA if They Engage In Activities Related to Digital Assets. The notice stated, in part: “FINRA is monitoring developments in the digital asset marketplace and is undertaking efforts to ascertain the extent of FINRA member involvement related to digital assets. To supplement FINRA’s efforts to date, FINRA is issuing this Notice to encourage each firm to promptly notify FINRA if it, or its associated persons or affiliates, currently engages, or intends to engage, in any activities related to digital assets, such as cryptocurrencies and other virtual coins and tokens.”
On November 8, 2018, the SEC issued a Cease and Desist Order against Zachary Coburn, the founder of EtherDelta, for violating Section 5 of the Exchange Act. EtherDelta was a secondary market trading platform for ERC-20 securities tokens. EtherDelta had not registered with the SEC as an ATS.
On July 8, 2019, the SEC and FINRA issued a Joint Staff Statement on Broker-Dealer Custody of Digital Asset Securities. The SEC and FINRA noted the need to comply with the customer protection rule, the books, records and financial reporting rules, and the SIPA protection requirements. The joint staff statement states: “As a threshold matter, it should be recognized by market participants that the application of the federal securities laws, FINRA rules and other bodies of laws to digital assets, digital asset securities and related innovative technologies raise novel and complex regulatory and compliance questions and challenges. . . . The Staffs encourage and support innovation and look forward to continuing our dialogue as market participants work toward developing methodologies for establishing possession or control over customers’ digital asset securities.”
The joint staff statement notes the following about noncustodial activities: “Generally speaking, noncustodial activities involving digital asset securities do not raise the same level of concern among the Staffs, provided that the relevant securities laws, SRO rules, and other legal and regulatory requirements are followed.”
On September 25, 2020, the SEC issued a no action letter to FINRA with respect to registered broker dealers that operate an ATS to trade digital asset securities. The SEC stated that it would not recommend enforcement action against a broker dealer that trades “digital asset securities” in the following manner: “(1) The broker-dealer operator maintains a minimum of $250,000 in net capital; (2) The agreements between the broker-dealer operator and its customers clearly state that the broker-dealer operator does not guarantee or otherwise have responsibility for settling the trades; (3) The broker-dealer operator has established and maintains reasonably designed procedures to assess whether a digital asset security was offered and sold initially pursuant to an effective registration statement or an available exemption from registration, and whether any secondary transactions of the digital asset security on or through the ATS are made pursuant to an effective registration statement or an available exemption from registration; and (4) The transactions in digital asset securities otherwise comply with the federal securities laws.”
SEC Anti-Money Laundering Requirements for ICOs and STOs
On February 13, 2018, in response to a letter from Senator Ron Wyden (see PDF), FinCEN made the following statement about the application of anti-money laundering requirements to ICOs that are structured as securities offerings: “To the extent that an ICO is structured in a way that it involves an offering or sale of securities or derivatives, certain participants in the ICO could fall under the authority of the SEC, which regulates brokers and dealers in securities, or under the authority of the CFTC, which regulates merchants and brokers in commodities. In such a case, the AML/CFT requirements imposed by SEC or CFTC regulations would apply to such ICO participants. Treasury expects businesses involved in ICOs to meet the BSA obligations that apply to them.”
SEC Disapproval of Bitcoin ETFs
Since 2017, the SEC has repeatedly disapproved the creation of exchange traded funds (“ETFs”) that would publicly sell commodity-trust ETF shares tracking the price of bitcoin. On February 26, 2020, in connection with an SEC rejection of a bitcoin ETF on that day, Commissioner Hester Peirce filed a dissenting statement that took issue with the SEC’s repeated rejection of exchange-traded bitcoin funds. The SEC disapproval letters are set forth below.
|Date||SEC Activity Approvals and Disapprovals|
|03/07/2017||SEC Order – Disapproval of Winkelvoss Bitcoin Trust ETF Listing on Bats BZX Exchange|
|03/28/2017||SEC Order – Disapproval of SolidX Bitcoin Trust ETF Listing on NYSE Arca Exchange|
|01/18/2018||SEC Staff Letter – Engaging On Fund Innovation and Cryptocurrency-Related Holdings|
|07/26/2018||SEC Order – Second Disapproval of Winkelvoss Bitcoin Trust ETF Listing on Bats BZX Exchange|
|07/26/2018||Dissent of SEC Commissioner Hester Peirce to Second Disapproval of Winkelvoss Bitcoin Trust ETF Listing|
|08/22/2018||SEC Order – Disapproval of ProShares Bitcoin ETF Listing on NYSE Arca Exchange|
|08/22/2018||SEC Order – Disapproval of Direxion Bitcoin ETF Listing on NYSE Arca Exchange|
|08/22/2018||SEC Order – Disapproval of GraniteShares Bitcoin ETF Listing on Cboe BZX Exchange|
|10/09/2019||SEC Order – Disapproval of Bitwise Bitcoin ETF Listing on NYSE Arca Exchange|
|02/26/2020||SEC Order – Disapproval of LIsting of Bitcoin and U.S. Treasury Bill ETF on NYSE Arca Exchange|
SEC Disapproval of Bitcoin Exchange Traded Notes
On August 15, 2018, U.S. citizens were permitted to purchase CXBTF, a bitcoin exchange traded note (“ETN”), which is issued by XBT Provider AB, a Swedish public limited liability company located in Stockholm. The ETN – Bitcoin Tracker One – is a debt instrument that synthetically tracks the average price of Bitcoin. The ETNs are traded on the Nasdaq Stockholm Exchange.
On September 9, 2018, the SEC issued a temporary Order of Suspension of Trading of CXBTF. The temporary order of suspension of trading terminates on September 20, 2018.
SEC Enforcement Actions
Since 2014, the SEC has brought a series of enforcement actions related to (i) assessing civil penalties for the sale of unregistered securities for bitcoin without having a private offering exemption, (ii) assessing civil penalties for securities fraud, and (iii) suspending the trading of publicly traded securities of certain companies that had a cryptocurrency business. Set forth below are copies of the SEC enforcement orders and court decisions.
|Date||SEC Orders and Enforcement Actions|
|09/18/2014||U.S. District Court E.D. Texas – Assessment of $40,404,667 Civil Penalty on Bitcoin Savings and Trust|
|12/08/2014||SEC Order – BTC Trading, Corp.|
|06/17/2015||SEC Order – Sand Hill Exchange|
|06/02/2017||U.S. District Court D. Conn. – SEC v Gaw Miners, LLC and Zen Miner, LLC|
|08/03/2017||SEC Order of Suspension of Trading – Strategic Global Investments, Inc.|
|08/09/2017||SEC Order of Suspension of Trading – CIAO Group, Inc.|
|08/23/2017||SEC Order of Suspension of Trading – First Bitcoin Capital Corp.|
|12/01/2017||SEC Complaint Against Plexcoin Initial Coin Offering|
|12/11/2017||SEC Order Terminating Munchee, Inc. Initial Coin Offering|
|01/25/2018||SEC Complaint Against AriseBank Initial Coin Offering|
|11/16/2018||SEC Order Against Airfox for Initial Coin Offering|
|11/16/2018||SEC Order Against Paragon for Initial Coin Offering|
|02/20/2019||SEC Order Against Gladius Network LLC for Initial Coin Offering|
|06/04/2019||SEC Complaint Against Kik Interactive Inc. for Initial Coin Offering|
|08/12/2019||SEC Order Against SimplyVital Health, Inc. for Initial Coin Offering|
|08/12/2019||SEC Temporary Restraining Order Freezing Assets of Veritaseum for Initial Coin Offering|
|09/18/2019||SEC Complaint Against IcoBox for Token Sales|
|09/20/2019||SEC Complaint Against Fantasy Market (Johnathan Lucas) for Token Sales|
|09/30/2019||SEC Order Against Block.one for Initial Coin Offering|
|10/11/2019||SEC Order Against Telegram for Sale of Grams|
|11/01/2019||SEC Consent Judgment Against Veritaseum for Initial Coin Offering|
|03/24/2020||U.S. District Court S.D.N.Y. – Preliminary Injunction Prohibiting Telegram from Distributing Grams Tokens|
|07/13/2020||SEC Order Against Plutus Financial (Abra) for Securities Swaps|
|09/30/2020||U.S. Districct Court S.D.N.Y. – Summary Judgment for SEC Against Kik for Unregistered Public Sale of Kin Tokens|
Criminal Prosecution for Securities Fraud in ICOs and STOs
During 2017, the U.S. Department of Justice initiated the prosecution of an individual who was alleged to have engaged in securities fraud with respect to two ICOs. A copy of the Complaint, dated October 27, 2017, is set forth below.
|Date||Criminal Complaint for Securities Fraud|
|10/27/2017||U.S. District Court E.D.N.Y. – Criminal Complaint for Securities Fraud in REcoin and DRC Initial Coin Offerings|
State Securities Regulator Enforcement Actions
State securities regulators also have the right to bring enforcement actions against companies that sell, to their state’s residents, any ethereum tokens or other digital assets that are deemed to be securities. Examples of Cease and Desist Orders from state securities regulators are set forth below.
This website provides general information about legal issues and developments in the law. Such materials are for informational purposes only and may not reflect the most current legal developments. These informational materials are not intended, and must not be taken, as legal advice on any particular set of facts or circumstances. You need to retain an attorney for advice on specific legal issues.