SEC Divisions Issue Digital Asset Securities Statement

On November 16, 2018, the Securities and Exchange Commission (SEC) Divisions of Corporation Finance, Investment Management, and Trading and Markets issued the Statement on Digital Asset Securities Issuance and Trading (the Statement) addressing the SEC’s recent enforcement actions involving and relating to digital asset securities.

At its core, the Statement is a confirmation of the applicability of the federal securities law framework to new and emerging technologies, such as blockchain. The Statement provides a concise summary of the circumstances under which the SEC has taken enforcement action against participants in the marketplace for digital asset securities. The Statement groups these actions into three categories, each of which corresponds to a fundamental aspect of the SEC’s statutory authority. Taken together, they form the framework for the SEC’s oversight of the securities markets: (1) initial offerings and sales of securities, (2) investment vehicles and investment advisors and (3) actors and institutions that develop and facilitate the secondary market for securities.

The takeaway from the Statement is that, once a digital asset has been identified as a security, it becomes subject to the oversight of the SEC. As a result, individuals dealing in that asset may be prohibited from engaging in a wide range of activities involving that digital asset unless those individuals and those activities comply with the federal securities laws.

Initial Offerings and Sales of Digital Asset Securities (the Securities Act of 1933)

On the same day that the SEC staff issued the Statement, the SEC also issued two settlement orders against issuers participating in unregistered offerings of securities in the form of digital tokens. The SEC entered separate orders finding that AirFox and Paragon and its owners offered and sold digital tokens in ICOs that were not registered under the Securities Act of 1933 and for which no exemption from registration was applicable. According to the order, AirFox and Paragon have undertaken to register the tokens under Section 12(g) of the Securities Exchange Act of 1934 and to file such periodic reports with the SEC as required pursuant to such registration. For additional commentary on this topic, please read our On the Subject, “ICOs Should Tread Carefully on Social Media.”

As emphasized in the Statement, these enforcement actions show a willingness by the SEC to bring unregistered ICOs into compliance. The AirFox and Paragon ICOs were conducted subsequent to the SEC’s Decentralized Autonomous Organization Report issued in July 2017 (the DAO Report), which is now being viewed as the first and only warning by the SEC. According to many commentators, the DAO Report marks a turning point after which the SEC will be subjecting ICOs and other activities in digital asset securities to full regulatory scrutiny. The Statement is consistent with this view.

When a digital asset is deemed a security by the SEC, the SEC staff expects that offers and sales of such digital asset will comport with the registration requirements of the federal securities laws. Unregistered offerings that do not rely on an applicable exemption from registration may become subject to similar enforcement actions.

Investment Vehicles and Investment Advisors (the Investment Company and Investment Adviser Acts of 1940)

On September 11, 2018, the SEC issued its first enforcement action regarding an investment company registration violation based on investments in digital assets. The SEC’s order states that Crypto Asset Fund, LLC, its manager, and its sole principal, Timothy Enneking, engaged in the business of investing, holding and trading certain digital assets that were investment securities. According to the order, the digital assets exceeded 40 percent of the fund’s assets, causing the fund to operate as an unregistered investment company. The order also states that Crypto Asset Fund was touted as the “first regulated crypto asset fund in the United States” and its management claimed to have filed a registration statement with the SEC.

The Statement reiterates that pooled holdings of digital asset securities, and the individuals that manage these holdings, must comply with the legal requirements applicable to investment companies. Investment vehicles and the individuals that advise others with regard to investments must meet the registration and regulatory requirements of the federal securities laws, regardless of the fact that the securities involved are digital asset securities.

Secondary Market for Securities (Securities Exchange Act of 1934)

On September 11, 2018, the SEC issued its first enforcement action charging unregistered broker-dealers for selling securities in the form of digital tokens. The SEC entered an order finding that TokenLot LLC, a self-described “ICO Superstore,” and its owners solicited and took orders for the sale of digital tokens in both ICOs and secondary market trading. According to the order, TokenLot handled hundreds of different digital tokens and the SEC found that these tokens included securities. TokenLot and its management performed such activities without registering as broker-dealers.

On November 8, 2018, the SEC also issued an enforcement action charging the founder of a digital token trading platform with operating as an unregistered national securities exchange. The SEC entered an order finding that EtherDelta and its founder facilitated a secondary market for the trading of ERC20 tokens by bringing together buyers and sellers for digital asset securities through the use of an order book, a website and smart contract execution on the Ethereum blockchain.

The Statement emphasizes that in making the determination of whether an individual, entity or platform is acting as a broker-dealer or an exchange, the SEC will conduct its analysis based upon the totality of the activities conducted by the participant as well as the functional reality of what those activities achieve. In circumstances where an entity provides a marketplace for bringing together buyers and sellers of digital asset securities, the SEC may find that such an entity is operating as an exchange. In circumstances where an individual or entity is effecting transactions in digital assets or buying and selling digital assets for its own account, the SEC may find that such an entity or individual is acting as a broker or dealer in securities.

Conclusion

The Statement is an affirmation by the SEC that regulation of digital asset securities falls squarely within its statutory authority and within its mission to protect investors, maintain fair, orderly and efficient markets, and facilitate capital formation. For participants in the digital asset economy, it is important to be aware of the various legal requirements that are being imposed on digital assets that are deemed to be securities. More importantly, such participants should be aware that the SEC, along with other regulators, are taking action to ensure that participants are complying with these legal requirements.

Although not mentioned in the Statement, the SEC has indicated that it is planning to release “plain English” guidance that will help issuers and potential issuers determine whether their digital asset is a security or not. Individuals and entities engaging in the digital asset marketplace should continue to seek legal advice regarding their activities.

For additional commentary on these enforcement actions, read our On the Subject, “Enforcing the Regulatory Landscape for Virtual Currencies: Recent Developments.” For additional information on securities laws as applied to token sales, see our Special Report, “Digital Offerings and Sales under Regulation S.” For additional information about McDermott’s FinTech and Blockchain practice, please see our practice group page.