Making Sense of a Wild Week in Cryptocurrency

While developments in the burgeoning blockchain technology and cryptocurrency industry typically come at a breakneck pace, last week was marked by particularly significant news. On consecutive days, the U.S. Securities and Exchange Commission (SEC) announced its position on certain initial coin offerings and token offerings and sales through blockchain or distributed ledger technology, a global digital currency exchange was hit with a significant fine for its failure to comply with U.S. law, and a local court decision highlighted one of the difficulties the industry must overcome to win the trust of consumers. These events, while disruptive in some respects, provide new opportunities for those willing to take their lessons to heart.

SEC Applies Federal Securities Laws to “New Paradigm” of Blockchain Technology

On July 25, the SEC issued an investigative report in which it announced its determination that certain digital tokens sold during an initial coin offering using blockchain or other digital ledger technology can be securities under the U.S. federal securities laws, and are therefore subject to the fundamental principal that they cannot be sold by issuers except pursuant to registration or a valid exemption from registration.  Additionally, securities exchanges providing for trading in these securities must register unless exempt.  These declarations come as no surprise to many in the cryptocurrency and token community, but nonetheless have far-reaching implications. It is both a boon and a distressing decision for ICOs and the blockchain space, generally. On the one hand, digital tokens and coins have been called securities by a U.S. regulator, which shows the industry is developing and becoming more accepted. On the other hand, the determination brings a new level of scrutiny for an industry not yet accustomed to regulatory oversight.

The July 25 SEC report resulted from an SEC Enforcement Division inquiry into unregistered sales of tokens by The DAO.  The SEC’s report can be found here and is worth reading. The SEC ultimately determined not to bring charges or make findings of violations, but this report may serve as a roadmap for those conducting ICOs and the SEC is unlikely to be as lenient with companies conducting token sales in violation of U.S. securities laws in the future. 

Key takeaways from the report include:

  • Digital coins and tokens offered and sold using distributed ledger technology such as blockchain can assume the characteristics of an investment contract, and therefore a security, where contributions of value (whether cash or another medium such as cryptocurrency) are made in a common enterprise with a reasonable expectation of profit derived from the managerial efforts of others.  The particular facts and circumstances related to the transaction and the offering are critical in the analysis.
  • A board or committee, such as The DAO’s “Curators,” that monitors, safeguards and makes decisions regarding contributions to the blockchain enterprise in lieu of meaningful control by the token investors is considered to be providing such “managerial efforts.”
  • A platform that provides a marketplace for, and facilitates purchase and sale of, securities such as The DAO’s tokens must register as a national securities exchange or operate pursuant to another exemption such as that afforded to alternative trading systems that register with the SEC as broker-dealers pursuant to Rule 3a1-1(a)(2). 


BTC-e Fined $110 million for Violating U.S. Anti-money Laundering Laws

On July 26, the day after the SEC’s report was issued, the U.S. Department of the Treasury’s Financial Crimes Enforcement Network, also known as FinCEN, announced a $110 million fine against BTC-e, one of the oldest digital currency exchanges for willfully violating U.S. anti-money laundering laws. As a money services business, BTC-e was required to implement certain anti-money laundering and know your customer policies and procedures, which it failed to do. In fact, BTC-e actively engaged in providing advice and aid to its users regarding processing illicit transactions, including money laundering and drug sales. Additional fines and criminal charges were also levied against the exchange’s owner, a foreign national.


Cryptocurrency Class Action Ruling Highlights Cryptocurrency Market Fears

On July 27, a U.S. district court judge in Florida ordered the payment of $8.2 million in damages by the cryptocurrency exchange Cryptsy in a class action lawsuit related to the theft of over 11,000 bitcoins. Notably, concern has been expressed in connection with the ability of the plaintiffs and the court to actually enforce the ruling, as the identified bitcoin wallets cannot be accessed without their related private keys. The ruling and related enforceability concerns highlight risks associated with the use of cryptocurrencies by consumers.


What Does it All Mean?

There are lessons to be learned from the events of the past week:

  • First and foremost, foreign entities and individuals are not exempt from U.S. law, nor are they beyond the reach of U.S. regulators and law enforcement agencies. U.S. law protects U.S. citizens, so cryptocurrency issuers and exchanges should carefully consider the implications of entering the U.S. market.
  • Issuers and participants in initial coin offerings and similar token sales should carefully consider the applicability of U.S. securities laws. The definition of security is relatively broad and can capture digital tokens. Absent registration, a valid exemption must be relied on.
  • Similarly, caution should be exercised in connection with the creation and operation of marketplaces for cryptocurrency tokens that are accessible by U.S. persons.  As with offerings, exchange operators need to be mindful of U.S. securities law related to the registration or valid exemption of such exchanges.
  • Turning a blind eye to U.S. anti-money laundering, know-your-customer and similar laws is likely to end badly.  While one of the selling points of cryptocurrency is anonymity, participants in the marketplace may be rewarded in the long run by addressing these matters up front and openly.  Greater transparency can result in greater trust and promote acceptance by consumers, governmental entities and existing financial institutions.

While the cryptocurrency industry is developing rapidly, the events of last week have made it evident that successful entities will combine transparency and compliance with U.S. and similar foreign securities and anti-money laundering laws to give investors and consumers the confidence to participate.  Existing financial institutions, FinTechs, and securities exchanges, already well versed in many aspects of compliance, may have the best opportunity to take proper advantage of regulatory interest and participate more fully in this developing and potentially paradigm-altering industry than ever before. 

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