Background
On September 27, we discussed the latest CFTC enforcement action involving cryptocurrencies in a client alert available here. In that case, the CFTC brought an enforcement action against a group of defendants for fraudulently soliciting investments for a pooled fund that traded the digital asset bitcoin. Interestingly, the pooled fund did not trade derivative instruments (e.g., futures, options, swaps). The CFTC nevertheless asserted its general jurisdiction over commodities under the Commodity Exchange Act. The CFTC’s view is that any digital asset-related transaction or solicitation that involves fraud or manipulation is within the CFTC’s territory.
We also have previously alerted readers to the prior SEC enforcement activities in connection with initial coin offerings ICOs, including the SEC’s pronouncement with respect to The DAO ICO (client alert available here), and the SEC’s suspension of trading of three already public companies in connection with the adequacy of their disclosures concerning their ICOs (client alert available here).
On September 29, 2017, in a first-of-its-kind action, the SEC charged a businessman and two companies with defrauding investors in a pair of ICOs. In its press release, the SEC alleges that Maksim Zaslavskiy (“Zaslavskiy”) and his companies, ReCoin Group Foundation (“ReCoin”) and DRC World (also known as Diamond Reserve Club) (“DRC,” and together with ReCoin, collectively, the “Companies”), sold unregulated securities in the form of cryptocurrencies, purportedly backed by assets that did not exist. According to the SEC’s complaint, investors in the Companies were told they could expect sizeable returns from the Companies’ operations, when the Companies had no real operations. As we have previously noted, an ICO that is premised on an increase in value of the token as a consequence of the profits of the issuers’ business operations, more closely resembles the issuance of a security than an ICO in which the token is redeemable for goods or services.
ReCoin was publicized as “The First Ever Cryptocurrency Backed by Real Estate.” Investors were told by Zaslavskiy that ReCoin had a “team of lawyers, professionals, brokers, and accountants” who would make real estate investments with the ICO proceeds. However, the SEC claims no personnel were hired or consulted to invest the raised funds. Additionally, the SEC has alleged that Zaslavskiy and ReCoin misrepresented that they had raised between $2 million and $4 million from investors, when only $300,000 had been raised.
Similarly, DRC was advertised as a cryptocurrency backed by investments in diamonds, and claimed that individuals could purchase “memberships” in the company to obtain discounts with product retailers. The SEC alleges that Zaslavskiy and DRC had not purchased any diamonds and had not engaged in any business operations.
Through an emergency court order by a federal district court in Brooklyn, New York, the SEC froze the assets of Zaslavskiy and of the Companies on the basis of violations of the anti-fraud and registration provisions of the federal securities laws. The SEC is pursuing permanent injunctions, disgorgement, interest, and penalties against the Companies and Zaslavskiy. Additionally, the SEC is seeking to bar Zaslavskiy from participating in any offerings of digital securities (“Security Tokens”) in the future.
The SEC’s actions follow its investor alert warning about the risks associated with ICOs, and its recent press release outlining the creation of a Cyber Unit and Retail Strategy Task Force, focused on policing cyber-based threats and protecting retail investors. The SEC’s creation of these new units was discussed in a previous Reed Smith client post available here.
Multiple Potential Regulators
The CFTC and SEC both have jurisdictional authority to pursue fraud and manipulation cases involving digital asses. This is not a unique situation. There have been other cases where multiple regulators brought enforcement actions concerning the same activity. Market participants should be cognizant of the risk that both agencies might bring enforcement actions against them that result in separate civil monetary penalties, as occurred in the BP and Hunter market manipulation cases involving both the CFTC and FERC.1
Neither the CFTC nor the SEC has exclusive jurisdiction over these products and markets. In the Hunter case, for example, the Court of Appeals for the D.C. Circuit cited the CFTC’s exclusive jurisdiction over futures to delineate between cases involving natural gas trading, which are within FERC’s jurisdiction generally, and cases involving natural gas futures trading, which fall within the CFTC’s exclusive jurisdiction over futures. Without such a distinction, it is possible for both, and even other regulators (e.g., the Department of Justice), to bring a case to court based upon the same endeavor.
The issuers of the tokens in the Zaslavskiy case are alleged to have fraudulently represented that their tokens were backed by assets. The SEC claims the underlying assets in Zaslavskiy had not been acquired or set aside by the promoters – the assets simply did not exist. One of the significant questions raised by the SEC’s recent actions is whether the SEC will recognize the distinction between a “Utility Token” and a “Security Token,” and how a true asset-backed token (e.g., oil or precious metals held in storage) will be regulated.
Conclusions
The CFTC and SEC have made clear that they will increasingly scrutinize ICOs and token issuances, and will devote more resources to enforcement actions. Accordingly, it is more important than ever that anyone contemplating an ICO understand how to comply and safely sponsor an ICO.
While there has been no guidance on how whitepapers should be structured to be compliant with federal securities laws, issuers may look to traditional Form S-1s or Reg. D private placement structures for guidance on creating a whitepaper for Security Tokens. Unfortunately, no clear regulatory currently exists for offerings of utility tokens, and utility token issuers must therefore be well advised as to the applicability of SEC and CFTC regulations to their ICOs. It is also abundantly clear that CFTC and SEC anti-fraud and anti-market manipulation regulations likely will apply.
While this alert focuses only on the most recent SEC and CFTC actions, any issuer must also be mindful of compliance issues arising under state laws, under other federal laws (e.g., banking and payments regulations), and under the laws of any country where a token might be issued or traded. Compliance with one set of laws and regulations does not guarantee compliance with the laws and regulations of any other state or country.
- Hunter v. F.E.R.C., 711 F.3d 155, 157 (D.C. Cir. 2013).
Client Alert 2017-234
