Like most who have invested in Bitcoin, I have been tracking the price four times a day. However, what we should all be tracking are the U.S. Securities and Exchange Commission (“SEC”) guidelines that address investing into cryptocurrency and the legal ramifications of using block-chain technology to raise capital.
On December 11, 2017, the Chairman of the SEC, Jay Clayton, issued the third in a series of statements about cryptocurrencies like Bitcoin and the use of “initial coin offerings” (ICOs) to sell digital coins/tokens to the public. The SEC, through its new Cyber Unit is actively working at regulating and even shuting-down companies in the crypto marketplace.
Example 1: https://www.reuters.com/article/munchee-ico/sec-halts-initial-coin-offering-from-restaurant-review-app-idUSL1N1OB17Q
Example 2: https://www.sec.gov/litigation/complaints/2017/comp-pr2017-219.pdf
SEC guidance and its actions should not be ignored. Here are three important takeaways:
1. SEC CONSIDERS DIGITAL COINS/TOKENS TO BE REGULATED SECURITIES.
The “Prime Directive” of the SEC is that all sales of securities, unless exempt, must register with the SEC. Regarding cryptocurrency, the SEC stated, back in July 2017, that depending on the facts and circumstances, “the offering (of virtual currency) may involve the offer and sale of securities.” Because this statement left too much wiggle room, the SEC in it’s December statement stated emphatically, “ the token [offering] constituted an investment contract and therefore was a security under our federal securities laws.” The SEC even noted that attempts to characterize cryptocurrency as tokens, were insufficient to avoid registrations requirements.
The SEC warned that “simply calling something a “currency” or a currency-based product does not mean that it is not a security.” The SEC was clear that it would look deeper into the structure of the transaction to determine if companies were selling a speculative investment. In addition, using the term “blockchain” will also not avoid scrutiny. Here are the two key quotes (emphasis added):
“…market professionals have attempted to highlight utility characteristics of their proposed initial coin offerings in an effort to claim that their proposed tokens or coins are not securities. Many of these assertions appear to elevate form over substance. Merely calling a token a “utility” token or structuring it to provide some utility does not prevent the token from being a security.
Said another way, replacing a traditional corporate interest recorded in a central ledger with an enterprise interest recorded through a blockchain entry on a distributed ledger may change the form of the transaction, but it does not change the substance.”
2. THE SEC WANTS INVESTORS TO ASK THE RIGHT QUESTIONS.
The SEC has noted that ICOs have not been publicly registered with the SEC. Being concerned, the SEC set out a series of questions investors should ask (and Company’s should disclose) when considering a cryptocurrency or ICO investment.
Sample Questions for Investors
- Who exactly am I contracting with?
- Who is issuing and sponsoring the product, what are their backgrounds, and have they provided a full and complete description of the product? Do they have a clear written business plan that I understand?
- Who is promoting or marketing the product, what are their backgrounds, and are they licensed to sell the product? Have they been paid to promote the product?
- Where is the enterprise located?
- Where is my money going and what will be it be used for? Is my money going to be used to “cash out” others?
- What specific rights come with my investment?
- Are there financial statements? If so, are they audited, and by whom?
- Is there trading data? If so, is there some way to verify it?
- How, when, and at what cost can I sell my investment? For example, do I have a right to give the token or coin back to the company or to receive a refund? Can I resell the coin or token, and if so, are there any limitations on my ability to resell?
- If a digital wallet is involved, what happens if I lose the key? Will I still have access to my investment?
- If a blockchain is used, is the blockchain open and public? Has the code been published, and has there been an independent cybersecurity audit?
- Has the offering been structured to comply with the securities laws and, if not, what implications will that have for the stability of the enterprise and the value of my investment?
- What legal protections may or may not be available in the event of fraud, a hack, malware, or a downturn in business prospects? Who will be responsible for refunding my investment if something goes wrong?
- If I do have legal rights, can I effectively enforce them and will there be adequate funds to compensate me if my rights are violated?
3. THE SEC WARNED LAWYERS TOO.
The SEC also provided a warning to lawyers against structuring an offer or sale of coins without first determining whether securities laws apply. Specifically, the SEC pushed back against lawyers and financial professionals who have created a potential offering framework (called a SAFT). The SAFT purport to provide a structure that fits within the most common securities exception, known as Rule 506 of Regulation D. This exception is commonly used by startup companies to sell equity to accredited angel investors and venture capital funds. It is unusually for the SEC to include such overt warnings to professionals in this manner. This may signal that such a structure will be challenged by the SEC, and each offering will likely need a very fact specific analysis before employing this framework. The SEC succinctly summarized its warning by urging, investors, companies and attorneys to use expertise and judgment to “focus on their responsibilities.” (emphasis added).
Reuben Ortega is a Co-Founder of Cloutier Ortega. Reuben represents public and private companies, entrepreneurs and investors in a variety of corporate and transaction matters. As a business consultant and general counsel, Reuben has managed all legal affairs for businesses including contracts, securities, corporate governance, and complex mergers and acquisitions. Reuben also enjoys helping with regulatory compliance, as he has been certified as an Information Privacy Professional by the International Association of Privacy Professionals.