Cleary Gottlieb on Government Scrutiny of Cryptocurrencies and ICOs

On Tuesday, September 11, 2018, Judge Raymond J. Dearie of the Eastern District of New York issued a decision holding that Initial Coin Offerings (“ICO”) may qualify as securities offerings and therefore be subject to the criminal federal securities laws. This ruling came as two U.S. regulators—the Securities and Exchange Commission (“SEC”) and the Financial Industry Regulatory Authority (“FINRA”)—announced separate actions under securities laws against companies engaged in the cryptocurrency marketplace, including the sale of digital tokens. As the popularity of cryptocurrencies grows and businesses and entrepreneurs increasingly turn to ICOs to raise capital, these developments may serve as guideposts for how cryptocurrencies and ICOs will be viewed by courts and federal regulators in cases to follow.

Background

In United States v. Zaslavskiy,[1] the Department of Justice (“DOJ”) alleged in an indictment that Maksim Zaslavskiy, the founder and sole owner of two companies purportedly in the business of investing in real estate and diamonds, engaged in securities fraud in connection with two unregistered ICOs through which he promised token purchasers profits from his companies’ investments. Specifically, the government alleged that Zaslavskiy violated securities laws by soliciting investments in two cryptocurrencies which he claimed were backed by real estate investments and diamonds, despite neither the tokens nor the underlying investments actually existing. Zaslavskiy moved to dismiss the indictment, arguing that (1) the underlying cryptocurrencies did not involve securities and therefore were not governed by securities law and (2) federal securities laws are unconstitutionally vague as applied to cryptocurrencies generally and specifically as to the particular underlying coins at issue in the case.

In denying Zaslavskiy’s motion, the court found that the government’s indictment satisfied requirements of due process and notice by alleging that the cryptocurrencies were investment contracts and thus securities. The court noted that the “subsidiary question of whether the conspirators in fact offered a security, currency, or another financial instrument altogether, is best left to the finder of fact . . .,”[2] yet the court considered the parties’ arguments to “confirm [its] conclusion that the Indictment calls for a trial on the merits.”[3] The court stated that the indictment pled sufficient facts that, if proven, would permit a finding under the Howey test[4] that “Zaslavskiy promoted investment contracts (i.e. securities), through the [cryptocurrency] schemes.”[5] Additionally, the court rejected Zaslavskiy’s argument that securities laws are vague as applied to his case on the grounds that “securities laws are meant to be interpreted ‘flexibly to effectuate [their] remedial purpose’”[6] and that Howey and its progeny have provided “clear guidance to courts and litigants as to the definition of ‘investment contract’ under the securities laws.”[7]

On the same day as the Zaslavskiy decision, the SEC announced it had settled charges against an “ICO Superstore” and its owners, while 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. In the Matter of TokenLot LLC., the SEC alleged that the respondents “promoted and sold digital tokens that included securities” without registering as a broker-dealer.[8] In its complaint, FINRA alleged that the respondent 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.[9]

Implications

Treatment of Cryptocurrencies as Securities: The approaches taken by Judge Dearie, the SEC, and FINRA illustrate the continued difficulty of determining consistent principles for when a cryptocurrency qualifies as a security. The court’s decision in Zaslavskiy suggests that general allegations that a cryptocurrency instrument satisfies the Howey test may be sufficient to fulfill requirements for indictments at the motion to dismiss stage. This relieves the government of a potentially significant pleading burden when bringing similar actions, but does not encourage clarification of clear standards for application of the Howey test and may create a risk of inconsistent determinations since the ultimate decision will be left to a jury. Nor is this unique to the criminal context – civil courts have made similarly sweeping findings in preliminary stages of litigation that certain cryptocurrencies may be securities, but have yet to issue final rulings based on specific factual findings. Similarly, the SEC’s summary conclusion in TokenLot that the tokens at issue “included securities,”[10] without even identifying those tokens, is in line with SEC Chairman Jay Clayton’s previous suggestions that most ICOs are securities, but does not explain the particular facts and circumstances that transformed those cryptocurrencies into securities. The SEC’s conclusion also seems to diverge with FINRA’s suggestion in its complaint that the underlying cryptocurrency was “transformed . . . into a security” only after it was “tied to [the company’s] stock,”[11] or the CFTC’s position that many cryptocurrencies are instead commodities. Thus, businesses and individuals engaged in digital currencies and ICOs must continue to pay close attention to the evolving landscape in enforcement actions for guidance on when cryptocurrencies are securities.

Piecemeal Guidance: Relatedly, the Zaslavskiy court’s rejection—particularly in a criminal context—of the “vague as applied” argument adds fuel to the ongoing debate about whether regulators have provided sufficient guidance on when virtual currencies will be deemed to be securities. Some in the industry have indicated an appetite for formal guidance on the SEC’s position on digital currencies, yet to-date guidance has come largely through enforcement actions, which offer narrow and irregular insight. As we previously explained, the SEC’s occasional standalone guidance, like The DAO report, has addressed only limited types of assets without consideration to the Investment Company Act or Investment Advisers Act, thus leaving key questions unresolved. And the Zaslavskiy court’s suggestion that “[w]hether and when the SEC chooses to engage in formal rulemaking regarding the regulation of digital assets is of no moment here” is unlikely to stimulate the SEC into greater action.[12]

Evolution in Enforcement Beyond Warnings and Fraud: Finally, TokenLot reflects a break in trend from prior SEC practice in multiple respects. Most notably, TokenLot stands in contrast to prior SEC cryptocurrency cases that have largely alleged outright fraud. In TokenLot, the SEC alleged no fraud, but instead that TokenLot’s promotion and sales of cryptocurrencies as an unregistered broker-dealer violated securities laws. Additionally, as the SEC’s press release emphasized, TokenLot is the SEC’s first case charging an unregistered broker-dealer for selling digital tokens after it issued its 2017 DAO Report. Together, this suggests that the SEC’s Cyber Unit will continue to expand the range of crypto-related cases that fall within its enforcement purview.

ENDNOTES

[1] Memorandum & Order, 1:17-cr-00647-RJD-RER (E.D.N.Y.), ECF No. 37 (Sept. 11, 2018).

[2] Id. at 7.

[3] Id. at 8.

[4] In SEC v. W.J. Howey Co., 328 U.S. 293 (1946), the Supreme Court set forth the foundational test for whether a transaction qualifies as a form of security known as an “investment contract.” Under Howey, an investment contract is a “contract, transaction, or scheme whereby a person invests his money in a common enterprise and is led to expect profits solely from the efforts of the promoter or a third party.” Id. at 298-99.

[5] Memorandum & Order, supra note 1, at 16.

[6] Id. at 19.

[7] Id. at 20.

[8] Securities Act Release No. 10543, Exchange Act Release No. 84075, Investment Company Act Release No. 33221, Administrative Proceeding File No. 3-18739, ¶ 2 (Sept. 11, 2018).

[9] Complaint, Dep’t of Enf’t v. Ayre, FINRA Office of Hearing Officers, Disciplinary Proceeding No. 2016049307801 (Sept. 11, 2018).

[10] TokenLot, supra note 8, ¶ 2.

[11] Complaint, supra note 9, ¶ 37.

[12] Memorandum & Order, supra note 1, at 21 n. 10.

This post comes to us from Cleary, Gottlieb, Steen & Hamilton LLP. It is based on the firm’s blog post, “Federal Court, SEC, and FINRA Scrutinize Cryptocurrencies and ICOs,” dated September 17, 2018, and available here.

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