The Securities and Exchange Commission (the "SEC") has regulatory authority over the issuance or resale of any token or cryptocurrency that has the characteristics of an "investment contract". Under Securities Act § 2(a)(1) and Securities Exchange Act § 3(a)(10), a security includes “an investment contract.” See 15 U.S.C. §§ 77b-77c. An "investment contract" has been defined by the U.S. Supreme Court 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. See SEC v. Edwards, 540 U.S. 389, 393 (2004); SEC v. W.J. Howey Co., 328 U.S. 293, 301 (1946).
If the token or cryptocurrency issuance is a security (because it is an "investment contract"), then the issuer must issue the security by means of either a registered securities offering or an exemption from securities registration requirements. The definition of issuer is broadly defined to include "every person who issues or proposes to issue any security" and "person" includes "any unincorporated organization." 15 U.S.C. § 77b(a)(4).
There are numerous federal private offering exemptions, including those that permit the sale of securities to the public, such as the intrastate offering and crowd-funding exemptions. However, as most startup companies do not solicit or advertise their securities to the public, the most frequently used exemptions are: (i) a Rule 506(b) offering to “accredited investors” only (which is not subject to state offering document requirements) and (ii) a Rule 504 offering of up to $5,000,000 to both accredited and non-accredited investors (which is subject to applicable state offering document requirements). Both of these private offering exemptions offer the advantage of being able to prepare a private offering memorandum that does not have to include certain disclosures and audited financial information found in a prospectus of a registered securities offering. The reduced disclosure requirements can significantly lower the cost of legal and accounting fees to prepare the offering documents and conduct the offering.
A Rule 506(b) offering that is restricted to “accredited investors” offers the advantages of (i) permitting the sale of securities in an amount that exceeds $5,000,000 and (ii) not being subject to certain state securities offering requirements. An individual investor is an “accredited investor” only if he or she (i) is a director or executive officer of the company issuing the securities, (ii) has an individual net worth (or joint net worth with a spouse) that exceeds $1 million, excluding the value of the investor’s primary residence, (iii) has an individual income that exceeds $200,000 in each of the two most recent years, and has a reasonable expectation of reaching the same individual income level in the current year, or (iv) has a joint income that exceeds $300,000 in each of the two most recent years, and has a reasonable expectation of reaching the same joint income level in the current year. A Rule 506(b) offering has the advantage of being automatically exempt from state securities registration, qualification and offering document requirements. However, the issuer must file a notice and pay a Rule 506(b) filing fee to each state in which its securities are sold. It should be noted that securities sold in a Rule 506(b) offering are “restricted securities” that are subject to certain resale restrictions.
In a private securities offering, the private offering memorandum and subscription agreement must be carefully prepared in order to reduce the potential liability that the securities offering will bring to the company, its directors, and its executive officers. If a securities offering has not been properly registered or exempted under applicable securities laws, a purchaser of securities can, subject to certain restrictions, file a lawsuit against the corporation to seek the rescission of his or her purchase. A purchaser of securities can, subject to certain restrictions, file a lawsuit against the company and its directors and executive officers for damages caused by an untrue statement of a material fact or an omission of a material fact that was made in the offering. There is other potential liability, including criminal penalties for willful violations of securities law.
Several class action lawsuits have been filed against companies that have conducted initial coin offerings that offered ethereum tokens to United States citizens. Copies of the complaints of some of these lawsuits are set forth below.
|Date||Private Securities Litigation Lawsuit|
|11/13/2017||Tezos ICO - Class Action Complaint in U.S. District Court M.D. Florida|
|11/26/2017||Tezos ICO - Class Action Complaint in U.S. District Court N.D. California|
|12/13/2017||Tezos ICO - Class Action Complaint in the U.S. District Court N.D. California|
|12/13/2017||Centra ICO - Class Action Complaint in the U.S. District Court S.D. Florida|
|12/21/2017||ATB ICO - Class Action Complaint in the U.S. District Court S.D. New York|
|12/28/2017||Giga Watt ICO - Class Action Complaint in the U.S. District Court E.D. Washington|
Since July 23, 2013, the SEC has issued a series of investor alerts and bulletins with respect to ponzi schemes using cryptocurrencies, bitcoin investments, ethereum tokens and initial coin offerings. The SEC's alerts and bulletins include the following:
|07/23/2013||SEC Investor Alert - Ponzi Schemes Using Virtual Currencies|
|05/07/2014||SEC Investor Alert - Bitcoin and Virtual Currency-Related Investments|
|07/25/2017||SEC Investor Bulletin - Initial Coin Offerings|
|07/25/2017||SEC Report of Investigation - Slock.it UG Decentralized Autonomous Organization Blockchain Tokens|
|08/28/2017||SEC Investor Alert - Public Companies Making ICO-Related Claims|
|11/01/2017||SEC Public Statement - Statement on Potentially Unlawful Promotion of Initial Coin Offerings and Other Investments by Celebrities and Others|
|12/11/2017||SEC Public Statement - Statement on Cryptocurrencies and Initial Coin Offerings|
In 2017, the SEC disapproved the creation of exchange traded funds ("ETFs") on the Bats BZX Exchange and the NYSE Arca Exchange that would publicly sell commodity-trust ETF shares tracking the price of bitcoin. The SEC disapproved the exchange rules changes required to permit both of the proposed ETFs, because the SEC found the bitcoin ETFs to be inconsistent with Section 6(b)(5) of the Securities Exchange Act, which requires, among other things, that the rules of a registered national securities exchange be "designed to prevent fraudulent and manipulative acts and practices" and to "protect investors and the public interest." 15 U.S.C. § 78f(b)(5). The SEC stated that the exchanges had not met this standard, because (i) the exchanges did not "have surveillance-sharing agreements with significant markets for trading the underlying commodity or derivatives on that commodity" and (ii) the "significant markets" for bitcoin are unregulated. The SEC disapproval letters are set forth below.
|Date||SEC Activity Approvals and Disapprovals|
|03/07/2017||SEC Order - Disapproval of Winkelvoss Bitcoin Trust ETF Listing on Bats BZX Exchange|
|03/28/2017||SEC Order - Disapproval of SolidX Bitcoin Trust ETF Listing on NYSE Arca Exchange|
|01/18/2018||SEC Staff Letter - Engaging On Fund Innovation and Cryptocurrency-Related Holdings|
Since 2014, the SEC has brought a series of enforcement actions related to (i) assessing civil penalties for the sale of unregistered securities for bitcoin without having a private offering exemption, (ii) assessing civil penalties for securities fraud, and (iii) suspending the trading of publicly traded securities of certain companies that had a cryptocurrency business. Set forth below are copies of the SEC enforcement orders and court decisions.
|Date||SEC Orders and Enforcement Actions|
|06/03/2014||SEC Order - Assessment of $50,843.98 Civil Penalties on CEO of SatoshiDICE and FeedZeBirds|
|09/18/2014||U.S. District Court E.D. Texas - Assessment of $40,404,667 Civil Penalty on Bitcoin Savings and Trust|
|12/08/2014||SEC Order - BTC Trading, Corp.|
|06/17/2015||SEC Order - Sand Hill Exchange|
|06/02/2017||U.S. District Court D. Conn. - SEC v Gaw Miners, LLC and Zen Miner, LLC|
|08/03/2017||SEC Order of Suspension of Trading - Strategic Global Investments, Inc.|
|08/09/2017||SEC Order of Suspension of Trading - CIAO Group, Inc.|
|08/23/2017||SEC Order of Suspension of Trading - First Bitcoin Capital Corp.|
|12/01/2017||SEC Complaint on Plexcoin Initial Coin Offering|
|12/11/2017||SEC Order Terminating Munchee, Inc. Initial Coin Offering|
During 2017, the U.S. Department of Justice initiated the prosecution of an individual who was alleged to have engaged in securities fraud with respect to two ICOs. A copy of the Complaint, dated October 27, 2017, is set forth below.
|Date||Criminal Complaint for Securities Fraud|
|10/27/2017||U.S. District Court E.D.N.Y. - Criminal Complaint for Securities Fraud in REcoin and DRC Initial Coin Offerings|
State securities regulators also have the right to bring enforcement actions against companies that sell, to their state's residents, any tokens or cryptocurrency that are deemed to be securities. Copies of Cease and Desist Orders from states securities regulators are set forth below.
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