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. Edwards, 540 U.S. 389, 393 (2004); SEC v. W.J. Howey Co., 328 U.S. 293, 301 (1946).
In making a determination as to whether an ethereum token or other 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). 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).
The Chairman of the SEC has 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."
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).
For offerings that are being made under a federal exemption from securities registration, the SEC places fewer restrictions on the sale of securities to "accredited investors." An individual investor is an “accredited investor” only if he or she (i) is a director or executive officer of the company 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)).
The two federal securities offering exemptions that would appear, at this time, to be the most useful for an ICO are (i) the Regulation A Tier 2 offering exemption (which requires the preparation of an offering circular) and (ii) the Rule 506(c) offering exemption (which requires the preparation of a private placement memorandum).
|Type||Description of Federal Securities Offering Exemption|
|Regulation A Tier 2||SEC Form 1-A must be filed. Offerings must be limited to no more than $50 million in securities. Permits a general solicitation to (i) accredited investors (with no individual investment limits) and (ii) non-accredited investors (with individual investment limited to 10% of annual income or net worth). Issuer only needs to receive self-certification of accredited investor status. Solicitation can be done by a website. Potential investors receive information through an offering circular that is publicly filed on the SEC EDGAR website, and then reviewed and qualified by the SEC. Not subject to state laws requiring pre-offering review and qualification. Ongoing public reporting required through annual, semi-annual and current reports. Non-affiliates of the issuer may resell their tokens immediately to both accredited and non-accredited investors. Affiliates of the issuer could theoretically resell their tokens under the SEC Rule 144 resale exemption, if they were able to comply with certain additional and complex restrictions regarding current public information, volume of sale, manner of sale, and SEC notice of sale. After holding their tokens for at least 90 days, affiliates of the issuer could theoretically resell their tokens to accredited investors under the resale exemption of Section 4(a)(7) of the Securities Act, if they were able to comply with certain information disclosure requirements and certain other resale restrictions.|
|Rule 506(c)||SEC Form D must be filed. No limitation on the offering amount. Permits a general solicitation to accredited investors (with no individual investment limits). Issuer must verify accredited investor status. Solicitation can be done by a website. Potential investors receive information through a private placement memorandum that is not publicly filed, reviewed or qualified by the SEC. Not subject to state laws requiring pre-offering review and qualification. No ongoing public reporting of financial information required. After holding their tokens for at least one year, non-affiliates of the issuer may use the SEC Rule 144 resale exemption to resell their tokens to both accredited and non-accredited investors. After holding their tokens for at least one year, affiliates of the issuer could theoretically resell their tokens under the SEC Rule 144 resale exemption, if they were able to comply with certain additional and complex restrictions regarding current public information, volume of sale, manner of sale, and SEC notice of sale. After holding their tokens for at least 90 days, both non-affiliates and affiliates of the issuer could theoretically resell their tokens to accredited investors under the resale exemption of Section 4(a)(7) of the Securities Act, if they were able to comply with certain information disclosure requirements and certain other resale restrictions.|
There are numerous other federal securities offering exemptions, including those that permit the sale of securities to the public, such as the intrastate offering and crowd-funding exemptions. However, as most startup companies do not solicit or advertise their securities to the public, the most frequently used exemptions for the sale of common or preferred stock are: (i) a Rule 506(b) offering to “accredited investors” only (which is not subject to state offering document requirements) and (ii) a Rule 504 offering of up to $5,000,000 to both accredited and non-accredited investors (which is subject to applicable state offering document requirements). Both of these private offering exemptions offer the advantage of being able to prepare a private offering memorandum that does not have to include certain disclosures and audited financial information found in a prospectus of a registered securities offering. The reduced disclosure requirements can significantly lower the cost of legal and accounting fees to prepare the offering documents and conduct the offering. A Rule 506(b) offering has the advantage of being automatically exempt from state securities registration, qualification and offering document requirements. However, the issuer must file a notice and pay a Rule 506(b) filing fee to each state in which its securities are sold. It should be noted that securities sold in a Rule 506(b) offering are “restricted securities” that are subject to certain resale restrictions.
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|
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 initial coin offerings. 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|
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.
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."
In 2017, the SEC disapproved the creation of exchange traded funds ("ETFs") on the Bats BZX Exchange and the NYSE Arca Exchange that would publicly sell commodity-trust ETF shares tracking the price of bitcoin. The SEC disapproved the exchange rules changes required to permit both of the proposed ETFs, because the SEC found the bitcoin ETFs to be inconsistent with Section 6(b)(5) of the Securities Exchange Act, which requires, among other things, that the rules of a registered national securities exchange be "designed to prevent fraudulent and manipulative acts and practices" and to "protect investors and the public interest." 15 U.S.C. § 78f(b)(5). The SEC stated that the exchanges had not met this standard, because (i) the exchanges did not "have surveillance-sharing agreements with significant markets for trading the underlying commodity or derivatives on that commodity" and (ii) the "significant markets" for bitcoin are unregulated. 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|
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|
|06/03/2014||SEC Order - Assessment of $50,843.98 Civil Penalties on CEO of SatoshiDICE and FeedZeBirds|
|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|
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 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.
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