Taming a Strange New Beast: Securities Regulators Take on Digital Currency
by Jack Falvey and Brendan Radke
The emergence of blockchain technology led in recent years to a surge in sales and trading of digital currencies – including well-known currencies like Bitcoin as well as hundreds of offerings of so-called digital “tokens” issued for use on individual websites. In 2017 and 2018 alone, more than $20 billion was raised through “initial coin offerings,” in which technology companies, typically startups, sold tokens for use on their web- based platforms. Federal and state regulators have scrambled to understand the technologies behind this new class of assets, including whether and by whom they should be regulated. The federal Securities and Exchange Commission (“SEC”) has been at the forefront in these efforts. In April 2019, after two years of proceeding in fits and starts, it recently issued guidance that finally seeks to set firm ground rules for issuers. This article reviews the SEC’s and other regulatory and enforcement responses to date, and the landscape going forward.
Digital Currency Basics
What is Blockchain Technology?
Digital currency is built on blockchain technology, often described as a “distributed ledger” digital technology. A blockchain is a form of online database that operates upon a peer-to-peer network of computers. Those networks may be decentralized, meaning that transactions upon the ledger are independently verified by individual computers (called nodes) accessing the network rather than being routed through a proprietary central data system. In a blockchain transaction, a user requests a transaction; that request is broadcast to the network of nodes; and those nodes verify the transaction and the user’s status through a known algorithm. Once verified, the transaction is combined with others and memorialized in entries called “blocks” of data for the ledger. Finally, the new block is cryptographically (i.e., securely) linked to the previous block after validation by the network, and added to the existing blockchain. The resulting blockchain is immutable, and the new block of data then is available to the next user on the chain. Major financial and technology firms have embraced and invested heavily in blockchain: it is widely expected to cut costs and processing times sharply in fields such as financial services and supply chains.
What is Digital Currency?
The best-known application of blockchain is Bitcoin, the digital currency created over a decade ago whose market value rose as high as $20,000 per digital coin at its peak in 2017 before falling sharply since. Bitcoin and its competitors (such as Ether and Litecoin) are sometimes referred to as “cryptocurrencies” – digital assets that can be used as exchange media in online commercial transactions with parties. The novelty of cryptocurrency is that it requires no third-party bank or other agency to clear transactions: the transfer occurs directly between two parties and is permanently memorialized on the blockchain. Cryptocurrencies are now exchange-traded and widely distributed, with growing acceptance among mainstream businesses.
Digital currency also includes so-called digital “tokens,” a term used because conceptually, they are said to operate like arcade tokens – they function like money on the host’s website. A digital token typically works on the framework of an existing blockchain (say, on the Ethereum blockchain) rather than a blockchain unique to the issuing company, and is generally capable of use only upon the issuing company’s application. Hundreds of companies have issued tokens as a feature of their applications – typically to attract users to the site and seek to build loyalty in a wide range of uses.
What is an Initial Coin Offering?
Issuers have offered tokens for sale in a process referred to as an “initial coin offering” or “ICO.” In advance of token sales, offerors have issued an offering document, usually referred to as a “white paper,” that generally described the company, its plans for the token sales and their intended use, and, to varying extents, how the issuer plans to use the proceeds from the token sales. Until recently, the offerors usually didn’t conceive of the tokens as securities, in part because the tokens had a designated utility on the offeror’s web-based platform, and in part because they were referred to as “tokens” or “coins.” The offering materials typically had nowhere near the required content of a registration statement that would need to have been filed with the SEC in an offering of securities.
Despite the often scant offering information, ICOs in the last several years attracted a community of purchasers who collected and traded the tokens. Issuers sold tokens in limited supply; and third parties launched unregulated, online trading exchanges through which tokens could be traded and their value bid higher than the issuing price. The result was a considerable amount of speculation on their value.
The market for digital tokens exploded in 2017 and early 2018. While available data is inexact, hundreds of ICOs are thought to have raised roughly $20 billion in those two years alone. Total funds raised through ICOs increased from 2017 to 2018, while at the same time the average offering size was halved, from an average of $24 million in 2017 to $12 million in 2018. ICOs were launched around the globe. Initially, China had the largest presence in this market (until it essentially outlawed them in late 2017). The United States accounted for most of the market in 2017, and the United Kingdom, Singapore, and Eastern European countries also became popular forums. Amounts raised have dropped sharply since early 2018, with an estimated $100 million having been raised in the first several months of 2019.
The SEC Takes on Digital Currency
The success of many ICOs and the subsequent climb in many tokens’ trading value commanded the attention of state and federal regulators in 2016 and 2017. The SEC saw a need to balance “support [of] innovation and the application of beneficial technologies” with concerns that issuers were essentially raising capital in defiance of securities laws.
The DAO Report and Munchee Order
In mid-2017 – after billions had already been raised through ICOs – the SEC began a series of incremental steps to delineate its regulatory and enforcement reach. In the so-called DAO Report issued in July 2017 (involving a virtual organization known as “the DAO”), the SEC announced that digital currencies were securities if they met the test for an “investment contract,” an enumerated type of security under the federal securities laws. The SEC applied the Supreme Court’s 1946 decision in SEC v. W.J. Howey Co. that defined an investment contract – essentially, any contract that involves an investment of money in a common enterprise with a reasonable expectation of profits from the efforts of others. The DAO Report found the digital token at issue to be a security, but under a relatively unique set of facts; the DAO currency carried with it voting and profit-sharing rights, which most digital currencies lack and which strongly resemble rights associated with common stock.
The next SEC action of note was its December 2017 Cease and Desist Order to a token issuer called Munchee that provided more generally-applicable guidance. The Munchee Order indicated that a token would likely be deemed a security if a company: primed purchasers to expect profits (e.g., by describing how a token would or could increase in value); broadly marketed tokens rather than targeting sales to users of the platform; and/or used proceeds from the token sale to further develop the platform. All of these activities suggested that the Munchee token met the key Howey factors: purchasers reasonably expected to profit from the efforts of others by holding the tokens and were investing in a common enterprise, i.e., development of the platform. The company agreed to shut down its offering.
SEC Enforcement Remedies for Failure to Register
In late 2017 and most of 2018, the SEC stepped up its public statements referring to digital currencies as securities. Top SEC officials noted that they were proceeding carefully but also that, as SEC Chairman Clayton stated in late 2017, he had “yet to see an ICO that doesn’t have a sufficient number of hallmarks of a security.” The SEC had issued dozens of investigatory subpoenas to issuers in 2017, but it had commenced few actions against digital currency offerors.
In late 2018, the SEC brought and settled two enforcement actions spelling out, for the first time, the remedies that it would demand where it determined that an ICO amounted to an unregistered securities offering. In each case it: imposed penalties of $250,000; required implementation of a public claims process whereby investors who purchased the tokens in the initial offering would notified of their rights to sue and a mechanism by which they could recover the consideration paid for the tokens plus any amounts to which they are entitled under Section 12(a) of the Securities Act; required registration of the tokens as securities; and required ongoing compliance with its public reporting requirements.
The SEC’s settlement in February 2019 settlement with Gladius Network was also significant, since it signaled the somewhat softer line it would take in a scenario where the issuer self-reported and cooperated. As with the prior settlements, the company agreed to register its tokens and establish a notice and claims process, but avoided any monetary penalty due to its self-report, cooperation, and remedial steps.
The April 2019 Investment Contract Framework and First No-Action Letter
Finally, and most recently, the SEC announced on April 3, 2019 two significant actions. First, it issued a “Framework for ‘Investment Contract’ Analysis of Digital Assets” (“Framework”) that, though not a rule or regulation, provides a roadmap for how the SEC intends to apply Howey. It states essentially that two factors drive its analysis: whether the purchaser would be relying on managerial efforts of others, and whether he or she anticipated profits from those efforts. Key factual considerations are: the state of development of the issuer’s network; whether company management continued to oversee it; and whether the issuer had taken any steps to enhance the token’s market price including its tradability on secondary markets. A token has a better chance of avoiding classification as a security if (1) the token is not designed for use as an investment, (2) the network on which it is utilized is complete prior to the sale, and (3) there is little, if any, opportunity for price appreciation.
On the same date, the SEC’s Corporation Finance Division issued is first “no-action letter” to a token issuer, allowing it to proceed with an unregistered token issuance on the issuer’s proposed terms, which aligned with the Framework factors. The requestor, TurnKey Jet, Inc. proposed to issue a token usable to purchase private jet services through its network. The SEC stated it would take no action against the company if the unregistered sale adhered to the proposed terms. Among the terms prescribed in the letter were that the tokens were usable immediately upon sale, TurnKey Jet would not use sale proceeds to develop its network, the tokens’ value was fixed at a dollar, they would be repurchased only at a discount and could not be used or transferred elsewhere, and that marketing would focus solely on the tokens’ functionality.
The Framework and no-action letter together provide a guide to whether and how an offeror may avoid having its token classified as a security and being subject to SEC registration and regulation. Alternatively, token issuers whose tokens will be deemed securities might be able to structure more restricted offerings so as to comply with any of several different exemptions: Regulation D, applicable to private offerings to qualified investors; Regulation S, a safe harbor applicable to offerings occurring solely overseas; or Regulation A+, providing a streamlined process for SEC registration, disclosure, and review of certain offerings capped at $50 million, with other restrictions. Finally, more established digital-token offerors may just bite the bullet and pursue a traditional securities offering. For example, in April 2019, blockchain software provider Blockstack filed with the SEC a securities registration statement for a $50 million token sale pursuant to Regulation A+.
Other Federal and State Law Enforcement
While the SEC has been the most visible actor, a range of government agencies have sought to regulate or launch enforcement matters in connection with ICO activity. They include:
U.S. Department of Justice: The Department of Justice has actively investigated and prosecuted a number of high-profile cases against individuals for fraud and money laundering based on deliberate and materially misleading statements in connection with ICOs and other token sales. Recent cases include United States v. Zaslavskiy, No. 17-CR-647 (E.D.N.Y.) (filed October 2017), the first federal criminal action against an ICO issuer; United States v. Rice, No. 3:18-CR-587-K (N.D. Tex.) (filed November 2018); and United States v. Crater, No. 19-CR-10063 (D. Mass.) (filed February 2019).
U.S. Commodity Futures Trading Commission: The Commodity Futures Trading Commission (“CFTC”) views certain digital currencies as commodities and has pursued enforcement actions and published extensive guidance in the area. It deems virtual currencies to be commodities under the Commodity Exchange Act, which prohibits fraud in the sale or trading of commodities and derivative instruments based upon commodities. Recently, two federal courts upheld the CFTC’s position that digital currencies are commodities.
Financial Crimes Enforcement Network: FinCen, the U.S. Department of the Treasury’s Financial Crimes Enforcement Network, has issued guidance concerning digital currency since 2013. In 2018, it announced that it too intends to apply its regulatory requirements to digital currencies, and on May 9, 2019, it issued extensive guidance describing how crypto businesses may be considered “money transmitters” and thus subject to the restrictions of the Bank Secrecy Act and other laws.
State regulators and Cross Border Actions: Securities and financial services regulators in Texas, Massachusetts, and New York all have brought recent enforcement matters. Cross-border, the North American Securities Administrators Association, an organization of state, provincial, and territorial securities regulators, announced a coordinated series of state and provincial enforcement actions in the United States and Canada.
The SEC has proceeded cautiously in its early years of addressing digital currency offerings. Ultimately, though, its enforcement matters in 2017 and 2018, capped by its April 2019 guidance, have sought to thwart the use of ICOs to raise operating capital without complying with securities laws. Going forward, those involved in digital currency offerings will need to navigate carefully the federal securities laws, other federal and state laws, and the efforts of myriad enforcement authorities who will be closely watching the digital currency arena for currency, antifraud, and other regulatory compliance.
Jack Falvey is a partner at Goodwin in Boston, where he represents companies and individuals in securities-related and other white collar matters as well as a range of complex civil litigation. He has represented digital currency issuers in matters before the SEC and other enforcement agencies. He was a federal prosecutor in Boston from 1994 to 2000.
Brendan Radke is a senior associate at Goodwin in San Francisco. His practice includes a variety of work within the cryptocurrency and blockchain sectors, as well as commercial, intellectual property, securities, and white collar litigation.
 Daniele Pozzi, ICO Market 2018 vs 2017: Trends, Capitalization, Localization, Industries, Success Rate, Cointelegraph (Jan. 5, 2019), https://cointelegraph.com/news/ico-market-2018-vs-2017-trends-capitalization-localization-industries-success-rate.
 #Crypto Utopia, Autonomous NEXT, https://next.autonomous.com/crypto-utopia (last visited May 16, 2019); Paul Vigna, Bitcoin Is in the Dumps, Spreading Gloom Over Crypto World, WSJ (Mar. 19, 2019), https://www.wsj.com/articles/bitcoin-is-in-the-dumps-spreading-gloom-over-crypto-world-11552927208?mod=searchresults&page=1&pos=5.
 Public Statement on Digital Asset Securities Issuance and Trading (Nov. 16, 2018), https://www.sec.gov/news/public-statement/digital-asset-securities-issuance-and-trading
 William Hinman, Director, Division of Corporation Finance, Remarks at the Yahoo Finance All Markets Summit: Crypto (June 14, 2018), https://www.sec.gov/news/speech/speech-hinman-061418.
 Report of Investigation Pursuant to Section 21(a) of the Securities Exchange Act of 1934: The DAO, Exchange Act Release No. 81207 (July 25, 2017), https://www.sec.gov/litigation/investreport/34-81207.pdf. (“The DAO Report”).
 Report of Investigation Pursuant to Section 21(a) of the Securities Exchange Act of 1934: The DAO, Exchange Act Release No. 81207 (July 25, 2017), SEC v. W.J. Howey Co., 328 U.S. 293, 299 (1946) (the definition embodies a “flexible rather than a static principle, one that is capable of adaptation to meet the countless and variable schemes devised by those who seek the use of the money of others on the promise of profits”);Tcherepnin v. Knight, 389 U.S. 332, 336 (1967) (“form should be disregarded for substance”); United Hous. Found., Inc. v. Forman, 421 U.S. 837, 849 (1975) (the emphasis should be “on economic realities underlying a transaction, and not on the name appended thereto.”); see 15 USC § 77(b)(a)(1) , Section 2(a)(1) of the Securities Act of 1933 and 15 U.S.C. § 78c(a)(10), Section 3(a)(10) of the Securities Exchange Act of 1934.
 The DAO Report, at 1, 3.
 Public Statement, SEC Statement Urging Caution Around Celebrity Backed ICOs (Nov. 1, 2017), https://www.sec.gov/news/public-statement/statement-potentially-unlawful-promotion-icos; In the Matter of Munchee Inc., Securities Act Release No. 10445 (Dec. 11, 2017), https://www.sec.gov/litigation/admin/2017/33-10445.pdf.
 Press Release, SEC, Two ICO Issuers Settle SEC Registration Charges, Agree to Register Tokens as Securities (Nov. 16, 2018) https://www.sec.gov/news/press-release/2018-264
 Gladius Network, LLC, Securities Act Release No. 10608 (Feb. 20, 2019), https://www.sec.gov/litigation/admin/2019/33-10608.pdf.
 Statement on Framework for “Investment Contract Analysis of Digital Assets” (Apr. 3, 2019), https://www.sec.gov/corpfin/framework-investment-contract-analysis-digital-assets.
 TurnKey Jet, Inc., SEC No-Action Letter (Apr. 3, 2019), https://www.sec.gov/divisions/corpfin/cf-noaction/2019/turnkey-jet-040219-2a1.htm.
 See 17 C.F.R §§ 230.500 et seq.; 17 C.F.R. §§ 230.901 et seq.; 17 C.F.R. §§ 230.251 et seq.
 The SEC largely concedes that the cryptocurrencies Bitcoin and Ether aren’t securities, in light of their decentralized and operational networks, but this will remain a fact-specific inquiry. The Director of its Division of Corporate Finance observed in June 2018: “[W]hen I look at Bitcoin today, I do not see a central third party whose efforts are a key determining factor in the enterprise… Applying the disclosure regime of the federal securities laws to the offer and resale of Bitcoin would seem to add little value… Over time, there may be other sufficiently decentralized networks and systems where regulating the tokens or coins that function on them as securities may not be required.” W. Hinman, Remarks at the Yahoo Finance All Markets Summit, https://www.sec.gov/news/speech/speech-hinman-061418; see also https://www.cftc.gov/Bitcoin/index.htm.
 See 7 U.S.C. § 1a(9) (commodities include “all other goods and articles … and all services, rights and interests … in which contracts for future delivery are presently or in the future dealt in”); In the Matter of Coinflip, Inc., d/b/a Derivabit, CFTC No. 15-29 (Sept. 17, 2015), https://www.cftc.gov/sites/default/files/idc/groups/public/@lrenforcementactions/documents/legalpleading/enfcoinfliprorder09172015.pdf; CFTC v. McDonnell, 287 F. Supp. 3d 213 (E.D.N.Y. 2018); CFTC v. My Big Coin Pay, Inc., 334 F. Supp. 3d 492 (D. Mass. 2018);
 McDonnell, 287 F. Supp. 3d at 228 and My Big Coin Pay, Inc., 334 F. Supp. 3d at 498.
 U.S. Dep’t of Treas., Letter to The Honorable Ron Wyden (Feb. 13, 2018), https://coincenter.org/files/2018-03/fincen-ico-letter-march-2018-coin-center.pdf; Kenneth A. Blanco, Director, FinCEN, Prepared Remarks at the 2018 Chicago-Kent Block (Legal) Tech Conference (Aug. 9, 2018), https://www.fincen.gov/news/speeches/prepared-remarks-fincen-director-kenneth-blanco-delivered-2018-chicago-kent-block; Kenneth A. Blanco, Director, FinCEN, Prepared Remarks at the 11th Annual Las Vegas Anti-Money Laundering Conference and Expo (Aug. 14, 2018), https://www.fincen.gov/news/speeches/prepared-remarks-fincen-director-kenneth-blanco-delivered-11th-annual-las-vegas-1; FIN-2019-G001, “Application of FinCEN’s Regulations to Certain Business Models Involving Convertible Virtual Currencies,” (May 9, 2019), https://www.fincen.gov/sites/default/files/2019-05/FinCEN%20CVC%20Guidance%20FINAL.pdf.
 In the Matter of Mintage Mining, LLC, Tex. State Sec. Board, Order No. ENF-19-CDO-1774 (Feb. 21, 2019), https://www.ssb.texas.gov/sites/default/files/Mintage_ENF_19_CDO-1774.pdf; 2018 Enforcement Report, Tex. State Sec. Board (Feb. 7, 2019), https://www.ssb.texas.gov/sites/default/files/YEAR_IN_ENF_2018_post.pdf; Press release, NASAA, State and Provincial Securities Regulators Conduct Coordinated International Crypto Crackdown (May 21, 2018), http://www.nasaa.org/45121/state-and-provincial-securities-regulators-conduct-coordinated-international-crypto-crackdown-2/; Letter, N.Y. Dep’t of Fin. Servs., In re Bittrex, Inc. (Apr. 10, 2019), https://www.dfs.ny.gov/system/files/documents/2019/04/dfs-bittrex-letter-41019.pdf.