Since the SEC began taking sporadic action against “unregistered” ICOs earlier this year, the entire industry has been stopped dead in its tracks.
And while legal pundits were able to put together a decent understanding of the situation based on SEC comments, opinion letters, and enforcement actions, there was no regulatory certainty.
We knew, for example, that the SEC considered ICOs to be securities offerings that required registration with the SEC or to fit within a registration exemption. But even knowing the general framework the SEC wanted the industry to pursue, it was unclear how exactly ICOs should proceed.
How does one launch a fully compliant security token? What does this mean for previously completed, but unregistered ICOs? If a token is a security, are centralized crypto exchanges required to register with the SEC like other securities exchanges? What about decentralized crypto exchanges?
Everyone has been waiting on the edge of their seats to hear the SEC’s response to these crucial questions. The answers to which can mean the difference between, on the one hand, successfully raising millions of dollars in capital and, on the other hand, spending the next few years in jail after being bankrupted by high-end white collar defense lawyers.
Fortunately, the SEC has finally spoken. In a public statement released last week, the SEC outlined some of the key requirements for ICOs, crypto investment vehicles, centralized and decentralized exchanges, and when crypto-related businesses must be registered Broker-Dealers.
This SEC statement brings more regulatory clarity to the industry and is pretty much in line with what we’ve predicted at Crypto Law Insider over the past year. To get a full rundown of the SEC’s statement and the implications these have for everyone involved, read on—
Initial Token Offerings
Though they’ve alluded to it before, the SEC has now explicitly elaborated their criteria for judging when a token is a security, which as we expected, is based on the US Supreme Court’s “Howey Test.”
My personal opinion is that it makes no sense to use a legal standard created ~70 years ago to determine whether a token is a security, but I don’t make the law, I just opine on it.
So now, we can say with certainty that ICOs must be registered with the SEC or fit within a registration exemption in order to avoid civil and criminal prosecution. As a result, all projects that want to raise money via a token offering must be prepared to face a long bureaucratic process of SEC compliance, which includes among other things, paying hundreds of thousands of dollars or more in legal and accounting fees.
Fortunately, it is still possible for projects to fit within a registration exemption. While this will not remove a project completely from SEC compliance requirements, it can significantly reduce the overall legal and compliance costs associated with a securities offering.
To demonstrate their authority and scare the rest of the industry into compliance, the SEC targeted two unlawful ICOs, AirFox and Paragon, which were both slapped with monetary fines, forced to retroactively register their securities offering and offer rescission rights to their ICO investors.
The manner in which AirFox and Paragon were treated is significant because it highlights the path to SEC compliance going forward for other ICO issuers who conducted unlawful securities offerings.
I have already been approached by several projects for assistance in becoming SEC-compliant, given that their ICOs are now considered “unlawful”. If you have previously launched an unregistered ICO and are worried that you’ll be targeted next, I recommend that you look into doing the same.
Crypto Investment Vehicles
The SEC is not just focusing its enforcement efforts on ICOs. Instead, the SEC is examining the entire crypto ecosystem to determine where SEC involvement is necessary, including investment vehicles that hold or advise on crypto.
In its guidance, the SEC confirmed that all crypto investment vehicles must operate consistently within the registration, regulatory and fiduciary obligations under the Investment Company Act. This means that businesses that act as pooled capital to invest in crypto (e.g., hedge funds, mutual funds, ETFs…) must be licensed like traditional funds.
To illustrate their stance, the SEC highlighted the September case of Crypto Asset Management and its founder Timothy Enneking, who was charged with failing to register the fund as an investment company.
Crypto Asset Management had billed itself as the “first regulated crypto asset fund in the US” but had never actually registered itself or its public offering of the fund. As punishment, the fund had to immediately cease operations, pay a $200,000 fine, and offer to buy back its shares from affected investors at the original offering price.
In recent years we’ve seen a proliferation of investment funds pop up in the crypto ecosystem. If you’ve set one of these funds up, this is a clear warning that now is the time to properly register your fund with the SEC.
The SEC confirmed that all securities trading platforms must be registered, regardless of whether they are centralized or decentralized. The SEC stressed that it will take a “functional approach” to determine whether a trading platform meets the criteria of being an exchange by taking into account the relevant facts and circumstances. The SEC will evaluate the activity that actually occurs between buyers and sellers, and not the technology or terminology, to determine whether the system operates as a marketplace that requires regulation.
The first victim of this ruling was EtherDelta, who the SEC fined $388,000 earlier this month. According to the SEC, EtherDelta—which was not registered with the SEC in any capacity—provided a marketplace for bringing together buyers and sellers of crypto through the combined use of an order book, a website that displayed orders, and a smart contract run on the Ethereum blockchain.
EtherDelta’s smart contract was coded to, among other things, validate order messages, confirm the terms and conditions of orders, execute paired orders, and direct the distributed ledger to be updated to reflect a trade. The SEC found that EtherDelta’s activities clearly fell within the definition of an exchange and that EtherDelta’s founder caused the platform’s failure either to register as an exchange or operate pursuant to an exemption.
Going forward, it’s clear that all exchanges will need to register with the SEC to stay on the right side of the law, and at a minimum should be prepared to introduce stronger KYC/AML processes.
As is the case with traditional securities, anyone that facilities the issuance of ICOs may be acting as a “broker” or “dealer” that is required to register with the SEC and be licensed by FINRA.
This means that anyone engaged in the business of effecting transactions in securities for the accounts of others must be licensed to do so. While we usually think of Investment Banks or Security Brokerage Firms as broker-dealers, this definition can be much broader.
The SEC highlighted the case of TokenLot, an “ICO superstore” where investors had the ability to purchase ICOs. Although TokenLot was not a traditional securities exchange, its activities included marketing and facilitating the sale of crypt, accepting investors’ orders and funds for payment, and enabling the disbursement of proceeds to the ICO issuers. TokenLot also received compensation based on a percentage of the proceeds raised in the ICOs, subject to a guaranteed minimum commission.
The SEC ordered TokenLot to pay penalties of approximately $500,000 in “disgorgement of profits” and banned its founders from operating another investment company for at least 3 years.
And TokenLot got off easy according to SEC officials.
“The penalties in this case reflect the prompt cooperation and remedial actions by TokenLot…” said Steven Peikin, Co-Director of the SEC’s Enforcement Division. “TokenLot…provided valuable information to Commission staff, stopped the conduct, and refunded money to investors.”
What does this mean for Crypto Law Insiders?
While it’s not pleasant to see crypto-related projects shut down, at least the SEC is providing regulatory clarity to the industry. These unpleasant actions will provide the necessary framework for Insiders to move forward.
Of course, it’s unlikely we will see the same kind of frenzied ICO activity as we did in 2017, though that may be a good thing given all the scams and frauds. Going forward, we should see an emphasis on more quality projects, backed by competent teams that are willing and able to procure SEC registration.
Insiders should be prepared for a big wave of SEC actions against previously completed but unregistered ICOs. I will be writing on that soon but I can’t emphasize enough how limited the window is for coming clean and getting compliant. The SEC has shown a path to compliance and it will expect issuers to take it. If you launched in ICO, I encourage you to seek legal counsel immediately. Failure to do so may result in a lot more than monetary fines.