November 21, 2018
by Larry E. Bergmann, Matthew B. Comstock, Maxwell T.S. Thompson

On November 16, 2018, the Divisions of Corporation Finance, Investment Management, and Trading and Markets (“Divisions”) of the Securities and Exchange Commission (“SEC” or “Commission”) issued the “Statement on Digital Asset Securities Issuance and Trading”[1] that provides some color concerning recent SEC enforcement actions from the perspective of these operating divisions.  Some key takeaways:

  1. The “well-established and well-functioning federal securities law framework” applies “regardless of whether the securities are issued in certificated form or using new technologies, such as blockchain;”[2]
  2. The Divisions will use a “functional approach” in assessing the application of the securities laws to entities operating in the digital assets space;
  3. The Commission has put market participants sufficiently on notice of the securities law requirements that apply to digital assets, and is now focusing on non-fraud violations; and
  4. Recent SEC enforcement actions provide a “path to compliance” with the federal securities laws going forward for issuers that have conducted an illegal offering of digital asset securities.

The Securities Law Framework

Although the Divisions state that they encourage technological innovations that benefit investors and the capital markets, and have been consulting with market participants about the issues presented by new technologies, and note that the SEC Chairman and various SEC staff members have provided perspective on some of the issues,[3][4]  the Statement provides little specific guidance to the industry about the application of the Securities Act of 1933 (“Securities Act”), the Securities Exchange Act of 1934 (“Exchange Act”), the Investment Company Act of 1940 (“Company Act), or the Investment Advisers Act of 1940 (“Advisers Act”) to issuance and trading of digital assets.

The Functional Approach

As indicated in the Statement section on trading markets, the Divisions will use a functional approach to assess whether an entity meets the requirements of the securities laws.  That approach will take into account the relevant facts and circumstances, and will disregard terminology used by market participants to characterize the particular activities and technology used to conduct offerings or trading or investment services for digitized assets.[5]  The Divisions state that the functional approach will be applied in the context of the broadly construed terminology used in the securities laws. 

Offers and Sales of Digital Asset Securities

For offerings of digital assets, such as “tokens,” the Statement points to the SEC’s “Report of Investigation Pursuant to the Securities Exchange Act of 1934: The DAO”[6] and the order issued in the Munchee, Inc.[7] enforcement action, concluding that “[t]ogether, the DAO Report and the Munchee Order emphasize that digital assets offered and sold as investment contracts (regardless of the terminology or technology used in the transaction) are securities.”[8]  The essential questions are: when is a digital asset a “security” for purposes of the federal securities laws?; and, if a digital asset is a security, what Commission registration requirements apply?  The Statement notes that the Commission has brought a number of enforcement actions involving fraudulent so-called Initial Coin Offerings (“ICO”s), but focusses here on two recent enforcement actions involving ICOs where fraud was not alleged.[9]  The “security” analysis relating to the offerings of digital tokens in these settled cases is very similar to the analysis in the DAO Report and the Munchee Order, essentially applying the flexible “investment contract” analysis of SEC v. W.J. Howey Co. and its progeny,[10]  so that aspect of these cases breaks no new ground.  However, as discussed below, these cases are significant for the “path to remediation” employed in connection with the settlements.

Investment Vehicles Investing in Digital Asset Securities

The Statement makes rather short shrift of Company Act and Advisers Act applications to investments in digital asset securities.  The focus is on the settled enforcement action involving Crypto Asset Management, LP[11] where the SEC found that “the manager engaged in an unlawful, unregistered, non-exempt, public offering of the fund, [and] invest[ed] more than 40 percent of the fund’s assets in digital asset securities and engag[ed] in a public offering of interests in the fund,” and made misleading statements to investors in the fund.  As a consequence, the Commission made findings of violations of the Company Act and the Advisers Act.

Trading of Digital Asset Securities

The Statement observes that some entities “colloquially referred to as ‘decentralized’ trading platforms … combine traditional technology (such as web-based systems that accept and display orders and servers that store orders) with new technology (such as smart contracts run on a blockchain that contain coded protocols to execute the terms of the contract).”  If such platforms “provide the means for investors and market participants to find counterparties, discover prices, and trade a variety of digital asset securities,” the platform operators must consider whether it is an “exchange” as defined in Exchange Act Section 3(a)(1) and the “functional test” contained in Exchange Act Rule 3b-16.  If it is an exchange, it must either register as such with the SEC or operate pursuant to an exception or exemption, such as Regulation ATS.  It is “the activity that actually occurs between buyers and sellers – and not the kind of technology or the terminology used by the entity operating or promoting the system – [that] determines whether the system operates” as an exchange.

Rule 3b-16(a) defines a platform as an exchange if it: “(1) brings together orders for securities of multiple buyers and sellers; and (2) uses established non-discretionary methods (whether by providing a trading facility or by setting rules) under which such orders interact with each other, and the buyers and sellers agree to the terms of a trade.”  It is clear that the functional approach will be liberally applied.  For example, the Statement discusses the term “order” used in the rule, again noting that “the actual activities among buyers and sellers on the system – not the labels assigned to indications of trading interest – will be considered for purposes of the exchange analysis.”[12]

The Divisions discuss the SEC enforcement action against the founder of EtherDelta, Zachary Coburn, noting that EtherDelta “provided a marketplace for bringing together buyers and sellers for digital asset securities through the combined use of an order book, a website that displayed orders, and a smart contract run on the Ethereum blockchain.”[13]  In a settled order, the SEC found that EtherDelta violated Exchange Act Section 5 by operating an unregistered securities exchange, and Mr. Coburn was found to have  caused EtherDelta to violate Section 5 because during the relevant period, he “founded EtherDelta, wrote and deployed the EtherDelta smart contract to the Ethereum Blockchain, and exercised complete and sole control over EtherDelta operations.”[14]

The SEC noted that EtherDelta had features similar to online securities trading platforms, and concluded that EtherDelta was operating as an exchange because,  among other things, it: (1) displayed an order book of “token pairs” and the top 500 orders to buy and sell, sorted by price and side (buy or sell) on a public website; (2) used a smart contract run on the Ethereum Blockchain that applied a pre-existing set of rules to allow buyers and sellers to interact; (3) set conditions for user eligibility on the platform; (4) maintained a list of official token listings; (5) limited order types to limit orders to buy or sell a token at a specific price; (6) stored all orders on a centralized server; and (7) effected trades by instructing the Ethereum Blockchain “miners” to run the EtherDelta smart contract to complete the trade.[15]  These features constituted bring together orders for securities of multiple buyers and sellers, and used non-discretionary rules to effect the trades.

The SEC does not address a “decentralized” system in which a person or entity issues software that allows users of the software who have wallets on a blockchain to trade directly with one another without any intermediation by a smart contract or otherwise.  A user could use the software in effect to post bids or offers to buy or sell securities that other software users could see.  If those other users are interested in buying or selling, they would communicate directly with the person who posted the bid or offer, and the parties would work out the terms of the trade on their own.  The securities sold would be transferred between wallets, but the software would not effect those transfers.  Rather, the buyer and seller would agree to and effect the transfer.

Tellingly, the Coburn order notes that about 92% of the transactions on EtherDelta occurred after the DAO Order was issued, i.e., Coburn was on notice that its activities required an exchange analysis.[16]

The Path to Compliance

Perhaps the most novel feature described in the Statement is its reference to the AirFox and Paragon orders as establishing a “path to compliance” for issuers that conducted illegal unregistered offerings of digital asset securities.  Section 5 of the Securities Act makes it illegal to offer and sell securities unless the offering is registered with the SEC or an exception or exemption is available.  Since the DAO Report was issued, the SEC has begun bringing cases alleging violations of Section 5 with regard to offerings of digital asset securities, such as tokens.[17]  A question that is heard frequently is: is there a way to resolve the Section 5 violation that will also allow the issuer to continue in business?    The AirFox and Paragon settlements appear to offer a way.  Rather than ordering disgorgement or insist on complete restitution, the Commission accepted undertakings from the issuers to:

(1) register its digital asset securities under Exchange Act Section 12(g) and maintain such registration for a period of at least one year;

(2) notify the public of their respective enforcement orders, and include a link to a Claim Form that will:

  1. Be distributed to all persons and entities that purchased the (illegally distributed) securities from the issuer advising them of their potential claims under Securities Act Section 12(a);
  2. Inform the purchasers that they may submit a written claim directly to the issuer asserting the purchaser’s assertion of rights under Section 12(a);
  3. Pay the amount due under Section 12(a) to persons filing a claim by the Claim Form deadline;[18] and
  4. File periodic reports with the SEC staff concerning claims and payments.[19]

Observations on the “Path”

These settlements are noteworthy for a number of reasons.  First, they require the issuers to register their securities under Exchange Act Section 12(g), even though they may not be required to register by the terms of that section.[20]  Section 12(g) registration imposes considerable costs on issuers, such as filing periodic audited public financial and operational reports.[21]  Second, they require the issuers to pay properly documented claims that could be made under Securities Act Section 12(a).  That section imposes liability for a person that offers or sells a security in violation of Securities Act Section 5: persons purchasing from the seller may sue at law or equity for rescission of the purchase price (subject to some adjustments).  Pursuant to the settlement, purchasers of the AirFox and Paragon securities can file a claim directly with the issuers and avoid the costs of litigation but receive the same rescissory compensation.[22]  It is also noteworthy that these requirements to offer to pay rescission do not need to be registered under the Securities Act, as most rescission offers are.[23]

Some matters will require further clarification.  Examples include:

  • What is the path for other issuers that have sold securities in violation of Section 5?
  • Can they register under Section 12(g) and make similar rescission/reimbursement offers to their purchasers? 
  • Must that be done in the context of an SEC enforcement action? 
  • Is this remedy available to issuers of non-digitized securities?
  • Is this remedy available to issuers who violate Section 5 after the date of these orders?
 

[2] Id.

[3] Statement n.2.

[4] Moreover, the Divisions point out that the Statement is “not a rule, regulation, or statement” of the SEC, nor has the Commission approved or disapproved of it.  Statement n.1.

[5] A functional approach is also consistent with the Howey test used for the “security” analysis.  See text at footnote 10 below.

[6] Exchange Act Release No. 81207 (July 25, 2017) (“DAO Report”), https://www.sec.gov/litigation/investreport/34-81207.pdf.

[7] Securities Act Release No. 10445 (December 11, 2017) (“Munchee Order”), https://www.sec.gov/litigation/admin/2017/33-10445.pdf.

[8] Statement n.4.

[9] Carriereq, Inc., d/b/a AirFox, Securities Act Release No. 10575 (November 16, 2018) (“AirFox Order”), https://www.sec.gov/litigation/admin/2018/33-10575.pdf; and Paragon Coin, Inc., Securities Act Release No. 10574 (November 16, 2018) (“Paragon Order”), . https://www.sec.gov/litigation/admin/2018/33-10574.pdf.  See also SEC Press Rel. 2018-264, “Two ICO Issuers Settle SEC Registration Charges, Agree to Register Tokens as Securities,” https://www.sec.gov/news/press-release/2018-264.

[10] See AirFox Order at paragraph 17; Paragon Order at paragraph 38.

[11] Securities Act Release No. 10544 (September 11, 2018), https://www.sec.gov/litigation/admin/2018/33-10544.pdf.

[12] “Order” is defined in Rule 3b-16(c) as “any firm indication of a willingness to buy or sell a security….” The Statement cites the discussion in the Regulation ATS adopting release that the determination of whether an indication of trading interest is “firm” will not depend on labels, but on what actually takes place between buyers and sellers.  See Exchange Act Release No. 40760 (December 8, 1998), 63 FR 70844, 70849-70850.

[13] Statement, text at n.12, citing Zachary Coburn, Exchange Act Release No. 84553 (November 8, 2018) (“Coburn Order”), https://www.sec.gov/litigation/admin/2018/34-84553.pdf.  See also SEC Press Rel. 2018-258, “SEC Charges EtherDelta Founder with Operating an Unregistered Exchange,” https://www.sec.gov/news/press-release/2018-258.  It may strike some observers as odd that the SEC did not charge the EtherDelta entity with violating Exchange Act Section 5.  However, the Coburn Order notes that Coburn sold the platform to foreign buyers in 2017, ceased to collect any fees from users of the platform, and does not currently operate EtherDelta.  The above press release also notes that the SEC’s investigation into the matter is ongoing.

[14] Coburn Order, paragraphs 23-28.

[15] Coburn also kept EtherDelta users apprised of key events and other announcements regarding the platform’s operations, and charged fees based on transaction volume.

[16] See Coburn Order at paragraph 4.  Curiously, the paragraph also states that the more than 3.6 million buy and sell orders “included securities,” but provides no details as to the nature of the securities or the proportion of the transactions that involved securities.

[17] See generally, Coburn Order. See also Securities Act Release No. 10544, Sept. 11 2018, https://www.sec.gov/litigation/admin/2018/33-10544.pdf

[18] The issuer may require claimants to submit documentation supporting the entitlement to receive payment under Section 12.

[19] The issuers also are subject to cease and desist orders from further violations of Section 5, and ordered to pay civil money penalties of $250,000.

[20] The Statement explains the rationale: “The registration undertakings are designed to ensure that investors receive the type of information they would have received had these issuers complied with the registration provisions of the Securities Act … prior to the offer and sale of tokens in their respective ICOs.  With the benefit of the ongoing disclosure provided by registration under the Exchange Act, investors who purchased the tokens from the issuers in the ICOs should be able to make a more informed decision as to whether to seek reimbursement or continue to hold their tokens.”

[21] Such reports can expose issuers to other liability.  See, e.g., Exchange Act Section 18.

[22] This remedy does not appear to be exclusive.  Purchasers would have the option to commence litigation under Section 12(a).  However, there is a one-year statute of limitations for such actions (see Securities Act Section 13).  The AirFox and Paragon offerings were made in October 2017, so it is possible that the settlement resurrects a rescission remedy.

[23] See Munchee Order, note 7 above, at n.2.