On November 16, 2018, the Securities and Exchange Commission (“SEC”) issued a statement on the application of federal securities laws to the issuance and trading of, and investment in, digital asset securities. While the statement encourages technological innovations that benefit investors and capital markets, it emphasizes that market participants must still adhere to federal securities laws when dealing with new technologies (such as blockchain and other distributed ledger technologies) in connection with digital asset securities.
The statement highlights several recent SEC enforcement actions involving the application of federal securities laws to new technologies. It notes that the issues raised in these actions generally fall into three categories: initial offers and sales of digital asset securities (including initial coin offerings (“ICOs”), investment vehicles investing in digital asset securities, and secondary market trading of digital asset securities.
Sales of digital asset securities
In discussing offers and sales of digital asset securities, the SEC focuses on two recently settled orders against AirFox and Paragon in connection with their unregistered public offerings of tokens in ICOs. These were the first SEC actions imposing civil penalties solely for ICO registration violations, and not because of fraud. Both AirFox and Paragon had failed to register their ICOs pursuant to the Securities Act of 1933, and neither qualified for an exemption to the registration requirements. Specifically, AirFox and Paragon raised approximately $15 million and $12 million worth of digital assets respectively by conducting ICOs in 2017, after the SEC warned that ICOs can be securities offerings in its DAO Report of Investigation.
In its settlements with AirFox and Paragon, the SEC is requiring them to register their tokens as securities, file periodic reports with the SEC, pay penalties, and return funds to harmed investors. In a press release announcing the settlement, Stephanie Avakian, Co-Director of the SEC’s Enforcement Division explained that “We have made it clear that companies that issue securities through ICOs are required to comply with existing statutes and rules governing the registration of securities. These cases tell those who are considering taking similar actions that we continue to be on the lookout for violations of the federal securities laws with respect to digital assets.” The statement suggests that the remedial measures undertaken by AirFox and Paragon show a path to comply with federal securities laws going forward, even when issuers have conducted unregistered offerings of digital asset securities.
Investing in digital asset securities
The SEC also takes a stance on investment vehicles investing in digital asset securities and those who advise others about investing in these securities. The statement warns that such investment vehicles and advisers must be mindful of registration, regulatory and fiduciary obligations under the Investment Company Act of 1940 and the Investment Advisers Act of 1940. In doing so, it points to the SEC order regarding Crypto Asset Management, which charged a digital asset hedge fund manager with registration failures and misrepresentations.
Secondary market trading of digital asset securities
Finally, the statement addresses secondary market trading of digital asset securities. It notes that the recent enforcement actions and staff statements on trading of digital asset securities have focused on what activities require registration as a national securities exchange or registration as a broker or dealer. A platform that offers trading in digital asset securities and operates as an “exchange” (as defined by the federal securities laws) must register with the SEC as a national securities exchange or be exempt from registration. The statement refers to the SEC action against the founder of EtherDelta, a platform that facilitated the trading of digital assets securities but was not registered with the SEC. In a previous post, we discuss the details of such enforcement action. The statement does not address the requirements that may apply to resellers of digital asset securities, regardless of whether such securities are traded on a registered exchange or through a registered broker-dealer.
A functional approach will be used when assessing whether a system constitutes an exchange under federal securities laws, focusing on the actual activity that occurs between the buyers and sellers and the existence of a marketplace, rather than how an entity may characterize itself or the particular technology used.
Also, the SEC notes that broker-dealer registration requirements may be applied to an entity trading or facilitating transactions in digital asset securities, even if it does not meet the definition of an exchange. It cites the recent SEC action involving TokenLot, a self-described “ICO superstore” that acted as a broker and dealer by facilitating the sale of digital assets, receiving compensation based on a percentage of proceeds from ICOs, and regularly purchasing and reselling digital tokens. As a result of such activities, TokenLot was ordered to comply with broker-dealer registration requirements. An entity that serves as a broker or dealer is required to register with the SEC, become a member of a self-regulatory organization (typically FINRA), and comply with legal and regulatory requirements governing registered broker-dealers.
The statement represents the views of the Divisions of Corporation Finance, Investment Management, and Trading and Markets of the SEC, and does not serve as a rule, regulation, or statement of the SEC. Nevertheless, it reveals how regulators within the SEC intend to apply federal securities laws to issuance, investment and trading activities in connection with digital asset securities that make use of new technologies such as blockchain.