The report, which included the SEC's ruling that cryptocurrency issued by the Decentralised Autonomous Organisation (DAO) is now classed as a security and, therefore, falls within the SEC's reach, is part of what appears to be a co-ordinated approach by US financial regulators and enforcement agencies, putting the crypto-industry — including issuers, exchanges and investors — on notice.
The day after the SEC report was published, BTC-e (a noted cryptocurrency trading platform and exchange) was taken down by the Financial Crimes Enforcement Network (FinCEN) and indicted by the US Department of Justice.
FinCEN levied a $110m penalty against BTC-e and a $12m fine against Alexander Vinnik, who is believed to be a senior figure in BTC-e’s operations. Vinnik is accused of 17 counts of money laundering and two counts of engaging in unlawful monetary transactions.
BTC-e was the exchange used to cash out 95% of the Bitcoin payments from ransomware attacks of the sort that crippled the NHS in the UK and many other organisations around the world in May, according to a report by Google.
Carol Van Cleef, a partner at Baker Hostetler and an expert on digital currency regulation, said the character of FinCEN’s indictment of BTC-e was unusual and called it a shot across the bow for exchanges. “Typically, when FinCEN takes action, there’s a lengthy investigation and the party is alerted to the fine and the action, and it’s all carefully negotiated,” she said. “Simply imposing a penalty without conversation with the other party is unique.
“The indictment indicates that exchanges, even those registered offshore [BTC-e is a Russian exchange], had best be ensuring they have practised good hygiene, because the US government is planning to pursue them."
The US Department of Justice last week shut down AlphaBay, a dark web marketplace and successor to the Silk Road. This involved the first ever seizures of cryptocurrencies other than Bitcoin and Ether.
Van Cleef believes that the fact that these actions by different arms of the US government came within such a brief window “was no coincidence” and indicates that regulators are taking the crypto-market extremely seriously.
Alfredo Silva, a partner at Morrison Foerster in the corporate team, said the moves indicated “an extraordinary level of co-ordination” and that he would not be surprised to see other jurisdictions follow suit.
The crypto industry has boomed in the last few months. Start-ups used initial coin offerings (ICOs) to raise over $1.2bn this year, many doing so because conventional means of raising capital would not have been available to them.
Charley Cooper, managing director of R3, a financial technology company aiming to bring blockchain to financial markets, and former COO of the US Commodity Futures Trading Commission, said: “Many companies have shied away from traditional means of fundraising because they are almost shell companies — just a couple of people with a white paper, no real revenue projections and only a loose business model. They wouldn’t get venture capitalists involved, so they turn to crypto.”
Silva agreed: “Half the benefit of ICOs was circumventing security laws.”
It is unclear what effect the report will have on ICOs. Brian Kelly, CEO of BKCM, an investment firm specialising in digital assets, said: “I’m told that not a single ICO has been pulled or shelved by the [SEC] ruling.”
Others, including Cooper, believe the more onerous requirements of SEC compliance will force companies to re-evaluate their business models.
Kelly added that the regulatory guidance would make the market more attractive to institutional investors.
This will not be an option for long, according to Cooper: “Many in the crypto-world thought regulators were not paying attention. They have absolutely been proved wrong.”
The SEC’s new stance
Such processes have a variety of names but are most commonly referred to as initial coin offerings (ICOs). A tech start-up creates a run of tokens registered on a blockchain — a form of distributed computer network where information is stored on all computers in the network, rather than on a central server — and sells them to investors.
Hitherto, such offerings have not been deemed securities, meaning that issuing entities did not have to make the usual regulatory disclosures to the SEC or to investors. This also meant that the tokens sold in such offerings could be marketed to non-accredited investors, often on social media.
While the SEC report deals only with tokens issued by the DAO, the full implications of the report could be colossal. The SEC report uses a set of criteria for determining something's status as a security known as the Howey Test. It is a common means of determining whether something is an “investment contract” and was established in a court case: SEC vs W J Howey Co. in 1946.
The Howey Test defines a security as “an investment of money in a common enterprise with a reasonable expectation of profits to be derived from the entrepreneurial or managerial efforts of others”, according to the SEC's report on the DAO.
Exactly which cryptocurrencies will be deemed securities is not yet clear but some are already making guesses. “It’s not clear how broadly it will be applied but I believe it’s telling that this report came from the Division of Enforcement. It’s not a policy discussion,” said Cooper. “They are taking this very seriously.”
Not all cryptocurrencies operate in the same way. The tokens involved in the DAO were something of a prototypical example of cryptocurrencies as securities. Silva said: “The DAO really is a perfect example. The token created a virtual venture fund and had all the qualities of a security.”
Many ICOs were conducted as pure capital raising exercises. Buyers had no use for the token beyond speculating that they would increase in value. “These are marketed using language familiar to investors: non-dilutive token equity, initial coin offerings,” said Silva. “The SEC pays attention to that.”
Lawyers agree that it is all but certain that such exercises are to be regarded as securities by the regulator.
Ether, the primary currency of the Ethereum platform, is not simply purchased for the purpose of speculating on its future value, but has a “utilitarian purpose behind it”, according to Van Cleef, because it is used to make use of Ethereum’s computing platform. As such, it is likely to be considered an asset, rather than a security, according to Silva.
Many other cryptocurrencies, including the first, Bitcoin, are in a murkier area. Those start-ups that have issued tokens should, according to Cooper, “call their lawyers.
“They need to make absolutely sure they can make a case that their tokens are not securities, or they need to immediately put the procedures in place to ensure they are compliant with SEC requirements for sellers of securities.”
Exchanges listing such tokens would likewise be well advised to require the same disclosures from them as they would for regulated securities, as exchanges can be prosecuted for hosting unregistered securities.
“Taking on DAO indicates that being registered abroad is no protection for an exchange if any transactions involve US citizens,” said Joshua Klayman, head of MoFo’s blockchain and smart contracts group.
Indeed, even private citizens may be affected by the SEC’s decision. Those who have purchased tokens in initial coin offerings and wish to sell them in the secondary market could be deemed securities sellers and required to register as such.
“If a token is deemed a security, then owners will have to be careful about finding exemptions to sell it privately. It could be a big concern for purchasers who looked at tokens as an investment,” said Daniel Kahan, also a member of MoFo’s blockchain and smart contracts group.
SEC takes on DAO
The DAO was launched on April 30 2016. It was intended to operate as a venture capital or investment fund but directed entirely by investors.
In May 2016, the DAO raised more than $150m from more than 11,000 investors through a token sale. Investors purchased DAO tokens with Ether, the cryptocurrency of the Ethereum network on which the DAO was built.
Investors were to vote on investment “contracts” presented by curators, determining how the fund’s cash was deployed.
On June 17 2016, a hacker was able to siphon off 3.6m ether — a third of the DAO’s fund — using security vulnerabilities already highlighted in a paper published in May 2016. Shortly thereafter, the fund was shuttered.
The SEC report on Tuesday ruled that DAO tokens were securities. Before the report, there was some question over whether an entity as decentralised as the DAO could be held to account by regulators.
But the SEC deemed that investors put money into the fund with the expectation of profiting from the managerial efforts of Slock.it, which created the fund and maintained its code thereafter, and that the tokens were therefore securities, according to the Howey test.