NOW: Reviewing SEC regulation of digital assets, October 2019

The Securities and Exchange Commission (SEC) continues to be an active regulator of digital assets, cryptocurrencies, cryptographic tokens, and other blockchain technologies.

Why would the SEC be contacting your company or fund if you transact in digital assets?

The SEC may consider your digital asset an unregistered security under the Securities Act of 1933. The SEC directs inquiries on the definition of a security for digital assets to the 2019 “Framework for ‘Investment Contract’ Analysis of Digital Assets,” which builds on the 2017 “DAO Report,” as the commission’s current application of the Howey Test. Unregistered digital asset exchanges and unregistered broker-dealers have seen enforcement actions as well.

What could happen next?

• Nothing. Enforcement priorities and lack of resources mean the SEC cannot investigate or enforce against all potential violators of securities laws in the global digital assets business. Any perceived lack of enforcement from the SEC in the crypto space should not be interpreted as safety or waiver from the commission.
• Just a chat. The SEC strongly encourages companies in the digital assets space to make an appointment and discuss issues in a live meeting. Wait times are long for these meetings, but they have the potential to provide clarity to companies long before the SEC takes action on its own. Companies should discuss any such proposed meetings with counsel.
• Staff letters. The SEC files “staff letters,” which are non-binding staff interpretations intended as guidance to aid in compliance. They are addressed to the public and do not require a response, even if you are in the type of business activity described in the letter. You may respond and engage with a response in order to learn more or provide an alternative interpretation. Since 2005, all staff letters and responses are made public by the SEC. The commission encourages this kind of interaction with the industry because digital assets are rapidly changing and can raise issues of first impression.
• A “comment letter” from the SEC addressed to your company or fund. The SEC staff sends these letters addressed to a company during the review process of a filing from that company. These letters represent the views of SEC staff, not necessarily the commission as a whole, and typically include requests for clarification or more information. The SEC maintains a page entitled “Engaging on Fund Innovation and Cryptocurrency-related Holdings,” containing eight responses from funds after a comment letter was sent to a fund that made a filing concerning a potential cryptocurrency-backed ETF. In October 2019, the SEC released an order declining to approve a crypto-based ETF over concerns the ETF could not meet its burden of sufficiently preventing manipulation and fraudulent activity.
• No-action letter. A no-action letter from the SEC staff may be requested by a private entity. If granted, the no-action letter states, based on the representations in the request letter, the SEC staff does not recommend enforcement. These letters are rare for digital assets, but 2019 saw two major no-action letters from the SEC. Turnkey Jet, Inc. was successful in obtaining a no-action letter for the company’s “token” sale in April 2019. However, the token’s functionality is minimal, with the no-action letter requiring Turnkey Jet to restrict the flow of tokens to their internal systems, not use any of the proceeds for developing their systems or app, and only allow the tokens to be redeemed for services. The limitations of the TurnKey Jet token likely mean few projects will rely on this no-action letter process. The SEC shows little interest in writing no-action letters for more robust token offerings. The “Pocketful of Quarters” cryptocurrency project obtained a no-action letter in July 2019 for their currency, which intends to unify payments on esports and video gaming platforms. The letter was conditioned on KYC/AML checks, restriction on transfer in secondary markets, and a fixed price at an infinite supply.
• Examination. The Office of Compliance Inspections and Examinations (OCIE) of the SEC has the goals of “promoting compliance, preventing fraud, identifying and monitoring risk, and informing policy.” Last year, the OCIE conducted 3,150 examinations of investment advisors, broker-dealers, custodians, and other intermediaries of the securities industry. Digital assets were listed as examination priorities for the OCIE in 2019.
• Investigation. Prior to an enforcement action, the SEC opens an investigation. For example, after an “Initial Coin Offering” (“ICO”) in December 2017, Overstock.com subsidiary tZERO was notified by the Department of Enforcement of the SEC that their Regulation D offering was being investigated as an unregistered offering in February 2018. The investigation process requested documents, which tZERO claims that it provided in full compliance. As of September 2019, no further action had been taken by the SEC, with tZERO claiming that the last document request it received was in December 2018.
• Cease-and-desist letter. The “crypto winter” of 2018 was kicked off by a cease-and-desist letter from the SEC to Munchee. The Munchee ICO was deemed an illegal sale of an unregistered security under the Howey Test despite Munchee’s claims the ICO was a non-security “utility token” because of its consumptive nature. Munchee complied fully with the letter by halting the ICO before any tokens were issued and refunding all purchases. The SEC then declined to enforce civil penalties.
• Wells Notice. A Wells Notice is a letter to a company or individual of the SEC staff’s intent to commence an enforcement action, providing the company with notice and the chance to submit a response. Most notable in the crypto space is the Wells Notice to, and subsequent response by Kik. Wells Notices and submissions are typically confidential, but Kik strategically made their notice and response public. In their response, Kik advanced arguments against their token’s classification as a security under the Howey Test. No enforcement action has been brought thus far, but future action is not precluded.
• Caution: Non-issuer trading platforms aren’t safe! Some projects have believed they could evade SEC scrutiny by being an intermediary platform for crypto instead of an issuer. ICO platform ICObox was charged as an unregistered broker for digital assets other than its own. In late 2018, the crypto-trading platform Etherdelta settled with the SEC for operating as an unregistered national securities exchange, after Etherdelta fulfilled over 3.6 million orders for ICO-type digital assets. In both cases, the SEC pursued the founders of each platform for civil penalties in their personal capacity.
• Something else. The foregoing list is not an exclusive nor exhaustive description of actions regulators could take. The digital assets space is evolving quickly technologically, but also legally. Accordingly, we strongly encourage engagement with counsel as soon as practicable in connection with any of the aforementioned regulatory actions or otherwise in connection with any action, positions, or other activity that may lead to regulatory action.

The foregoing has been prepared for the general information of clients and friends of the firm. It is not meant to provide legal advice with respect to any specific matter and should not be acted upon without professional counsel. If you have any questions or require any further information regarding these or other related matters, please contact your regular Nixon Peabody LLP representative. This material may be considered advertising under certain rules of professional conduct.