March 14, 2018
by James Dombach, Matthew B. Comstock

As discussed in Stephen Crimmins’ article “SEC Cautions on Trading Platforms,”[1] the SEC’s Divisions of Enforcement and Trading and Markets put forth a “Statement on Potentially Unlawful Online Platforms for Trading Digital Assets” regarding the legal ramifications of online trading platforms that offer coins and tokens sold as part of Initial Coin Offerings (“ICOs”).  In particular, the Divisions cautioned that such platforms operate as “exchanges,” as defined by the federal securities laws.  The ramification of such a designation is that the platform must register with the SEC as a national securities exchange or be exempt from registration -- practically meaning registration as an alternative trading system (“ATS”).  Each path is fraught with its own pitfalls that need to be carefully examined.  But for those entities already in operation and potentially within the crosshairs of the SEC, the only viable business option is to register as an ATS.

Registration as a National Securities Exchange

For those entities already in operation and selling tokens that the SEC would consider securities, the national securities exchange registration path is most likely going to be unworkable from a business perspective.  A national securities exchange must register with the SEC under Section 6 of the Exchange Act.[2]  Before an exchange can commence operations, the SEC must approve its application for registration filed on Form 1. 

The process to be approved as a national securities exchange is not a short process.  For those exchanges simply trading already-listed securities, the application process, from publication of the application to approval, typically lasts a year.  And this timeline does not include the behind-the-scenes discussions with the SEC prior to the application ever being submitted.  This process is going to be exponentially more complicated by incorporating the trading of security tokens.  For instance, the data associated with these new tokens will need to be incorporated into the public market data stream.  It is unclear how blockchain technology running such exchanges would interact with the Securities Information Processors (“SIPs”). 

Additionally, the member regulatory requirements of national securities exchanges as self-regulatory organizations will likely pose a tricky issue given the decentralized nature of tokens.  Section 6(c)(1) of the Exchange Act prohibits exchanges from granting membership to any person not registered as a broker-dealer, or associated with a broker-dealer.[3]  Therefore, any access to the national securities exchange must be through a broker-dealer, which will necessarily raise a host of issues associated with broker-dealer regulation.  Further, from a business perspective, such a requirement may be inherently inconsistent with the use of blockchain technology and the elimination of intermediaries, undoing the benefits associated with the use of blockchain technology.

Choosing the national securities exchange route is simply impractical for those platforms wanting to continue trading security tokens while minimizing operational disruptions.  The complexity of incorporating an exchange trading tokens into the national market system does not comport with the rapid registration of such an exchange with the SEC.

Registration as an Alternative Trading System

As compared to a national securities exchange, the registration of an ATS with the SEC is more streamlined; however, the creation of an ATS trading tokens will invariably require significant back-and-forth with the SEC.  An ATS, unlike a national securities exchange, does not have to obtain SEC approval before commencing operations.  Rather, to become an ATS, Rule 301(b) of Regulation ATS requires an entity to register as a broker-dealer and to file Form ATS with the SEC.  Rule 301 of Regulation ATS requires an ATS to file a Form ATS with the SEC 20 days before commencing operations as an ATS.[4]  Form ATS is not an application and the SEC does not “approve” an ATS before it begins to operate.  However, the SEC staff will often undertake an informal review of a Form ATS, and the ATS will need to address any deficiencies noted by the SEC staff. 

But the registration of an ATS trading tokens is not without its own pitfalls.  First, with respect to completing the Form ATS, failure to sufficiently describe the operations of the ATS may lead to enforcement actions by the SEC.[5]  Additionally, material changes to the operation of an ATS requires an amendment at least 20 days prior to implementing such change.  But the SEC has not provided definitive guidance on what constitutes a “material change” and it is not difficult for an ATS to run afoul of these requirements.

Additionally, an ATS will have a similar gatekeeping function as national securities exchanges implementing listing standards.  In particular, Rule 15c2-11 requires a broker-dealer wishing to publish any quotation for a security in a “quotation medium” (which includes an ATS) to gather specified information regarding the issuer.[6]  Once a broker satisfies the requirements of Rule 15c2-11 and has begun quoting in the subject security, other brokers can “piggyback” on such quotations without having to satisfy the requirements of Rule 15c2-11.[7]  This gatekeeping function will require the gathering of certain types of information from the issuer and require the broker-dealer gathering such information to have a reasonable basis to believe that the information is accurate.  Non-compliance with Rule 15c2-11 can result in violations of Section 15 fraud provisions.

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Any platform currently trading or contemplating trading security tokens needs to quickly analyze the necessary steps to comply with the SEC’s latest edict.  Murphy & McGonigle’s unique expertise in cryptocurrency, Exchange registration, and ATS registration place it in a prime position to help token platforms navigate SEC registration requirements.

 

[2] 15 U.S.C. 78f.

[3] 15 U.S.C. § 78f(c)(1).

[4] See 17 CFR § 242.301(b)(2)(i).

[5] See, e.g., In the Matter of Credit Suisse Securities (USA) LLC, Release No. 34-77003 (Jan. 31, 2016); In the Matter of ITG Inc., Release No. 34-75672 (Aug. 12, 2015).

[6] 17 CFR § 240.15c2-11.

[7] 17 CFR § 240.15c2-11(f)(3).