The United States Securities and Exchange Commission (SEC) Chairman Jay Clayton issued a public statement on December 11, 2017 providing his general views on cryptocurrencies and initial coin offerings (ICOs) and offering advice to prospective investors and market participants. Since then, the SEC has halted one ICO for conduct which constituted an unregistered securities offering and also suspended trading in a small cap stock that trades in digital coins and cryptocurrencies.
SEC Chairman Statement
Mr. Clayton's public statement acknowledged that many of the important questions in the cryptocurrency and ICO market - such as whether a product and offering are legal - require in depth analysis, and that the answers to such questions may differ depending on a number of factors. In his statement, Mr. Clayton did not seek to definitively answer these questions, but rather sought to offer his general views on the cryptocurrency and ICO market. He directed his initial comments at (i) "main street" investors, and (ii) market professionals (including broker-dealers, investment advisors, exchanges, lawyers and accountants) before continuing to discuss more broadly cryptocurrencies, ICOs and securities regulation.
(a) Considerations for "main street" investors
In the spirit of investor protection, Mr. Clayton cautioned "main street" investors about the risks associated with participating in the cryptocurrency and ICO markets. He cited the fact that no ICO to date has been registered with the SEC. Furthermore, he pointed out that many of the ICO and cryptocurrency markets span national borders and that, as a result, invested funds may travel overseas quickly without investors' knowledge and that the SEC may not be able to effectively pursue bad actors. Mr. Clayton also provided a list of "due diligence" questions that all "main street" investors should ask when considering whether to invest in cryptocurrency and ICO products.
(b) Considerations for market professionals
On ICOs: Mr. Clayton noted that, following the release of an investigative report (PDF) by the SEC into the DAO, a number of market professionals have attempted to highlight the utility features of their proposed ICO in an effort to claim that the token or coin is not, in fact, a security. Consistent with the concerns raised by Canadian securities regulators in their notice from August 2017, as discussed in our August MarketCaps, he stated that many of these claims elevate "form over substance".
Mr. Clayton also reminded market participants that tokens and offerings which incorporate features and marketing efforts emphasizing the potential for profits based on the entrepreneurial or managerial efforts of others continue to contain the hallmarks of a "security" under U.S. law. Mr. Clayton indicated that, moving forward, he expects gatekeepers, including securities lawyers, accountants and consultants to focus on their responsibilities. He further urged market professionals to be guided by the principle of investor protection and, in particular, the protection of "main street" investors.
On cryptocurrencies: Mr. Clayton emphasized two points on cryptocurrencies:
(i) calling something a "cryptocurrency" does not mean that it is not a "security". Prior to launching a cryptocurrency or a product connected to the value of a cryptocurrency, promoters need to either (a) exhibit that the currency or product is not a security, or (b) comply with securities laws.
(ii) brokers, dealers and other market participants that accept payment in cryptocurrencies, coordinate purchases of cryptocurrencies or otherwise use cryptocurrencies to facilitate securities transactions should exercise caution and not lose sight of anti-money laundering and "know your client" obligations.
(c) General discussion on cryptocurrencies, ICOs and securities regulation
Mr. Clayton also broadly outlined the concepts underpinning cryptocurrencies and highlighted some of their pros and cons. He stated that whether or not a cryptocurrency is beyond the jurisdiction of the SEC will depend on the characteristics and use of that particular asset. He noted that just as the SEC has a sharp focus on how U.S. dollar, euro and Japanese yen transactions effect the securities market, so too does the SEC have an interest in how cryptocurrency transactions effect the securities market.
Mr. Clayton also provided commentary on the ICO market and offered perhaps the clearest statement yet by a SEC representative about the regulatory implications of an ICO: "By and large, the structures of initial coin offerings that I have seen promoted involve the offer and sale of securities and directly implicate the securities registration requirements and other investor protection provisions of our federal securities laws."
Following this statement, Mr. Clayton highlighted the fact that he has asked the SEC's Division of Enforcement to police the ICO space vigorously and to recommend enforcement actions against those that conduct ICOs in violation of the federal securities laws.
SEC actions in light of Clayton's comments
On December 11, 2017, the same day as the Chairman's comments, the SEC also announced it had issued an order that an ICO by a California startup constituted an unregistered security offering. The SEC intervened in an offering by Munchee Inc., a start-up that was attempting to raise capital through the issuance of its own cryptocurrency. Munchee, for its part, cooperated with the investigation, refunded the money it had received from investors in the prospective offering and also consented to the SEC order.
The press release by the SEC noted some of the factors that had persuaded it that Munchee was offering a security, pointing out that Munchee had emphasized to prospective investors that the tokens they would receive did not have a fixed value, but would increase due to the efforts by the company and others. Munchee also indicated to investors that it would create and support a secondary market for the exchange of its tokens. Collectively, these were taken to signal to investors that their investment would yield returns from the efforts of others, the hallmark of a "security".
While the SEC declined to take additional steps, such as levying a penalty, it noted that it did so because of (i) Munchee's cooperation and compliance upon the SEC intervening, and (ii) the lack of harm to investors, since no tokens had actually been issued. Implicit in that acknowledgement was the warning that other offerors may not get off so lightly, and there could be a serious bite to SEC sanctions if it deems it necessary.
On December 19, 2017, the SEC suspended trading of shares in Crypto Co., an over-the-counter issuer whose stock has surged more than 2700% this month. Crypto Co. had promoted itself as "the first and only reporting company offering a portfolio of digital assets, technologies and consulting services to the blockchain and cryptocurrency markets."
The SEC outlined its concerns relating to the "accuracy and adequacy of information in the marketplace about, among other things, the compensation paid for promotion of the company, and statements in Commission filings about the plans of the company's insiders to sell their shares of The Crypto Company's common stock." The trading suspension will be lifted on January 3, 2017.
For investors and offerors alike, who are interested in participating in or conducting ICOs, Clayton's statements and recent enforcement actions on both sides of the border (for Canada, see recent sanctions for contempt against those involved with Plexcoin, and related SEC emergency action) should underline the need for responsible practices. No longer can participants in ICOs and cryptocurrencies turn a blind eye to the existing securities regulatory framework. Accordingly, prior to entering into this exciting space, one should consult with a legal professional. Gowling WLG has already been working with organizations contemplating ICOs to determine whether or not Canadian securities laws apply to their ICOs and if so, how they can conduct their ICOs in compliance with Canadian securities laws.
We have also been engaged with securities regulators across Canada, through the CSA Regulatory Sandbox and otherwise, on issues relating to ICOs and other innovations in the fintech, securities crowdfunding and alternative finance space. While clear on the need to fulfil their regulatory mandate, Canadian securities regulators want to encourage innovation and facilitate capital raising by fintech businesses.
Organizations contemplating an ICO should consult with legal counsel - the following members of Gowling WLG's Capital Markets/Crypto team would be pleased to assist:
Gowling WLG is the only international law firm to be a partner and co-founding member of the Blockchain Research Initiative, a multi-million dollar research initiative into blockchain, which includes the Government of Canada, Bank of Canada, Nasdaq, the TMX Group, IBM and many others.