The SEC’s Recent Approach To Cryptocurrency
ATTORNEY: VILLI SHTEYN
POMERANTZ MONITOR SEPTEMBER/OCTOBER 2019
At first glance, the U.S. Securities and Exchange Commission (the “SEC”) has had a reserved and seemingly inconsistent approach to cryptocurrency, at times stepping into the fray for enforcement actions against a particular cryptocurrency it deems a security, but often staying out of the picture and refusing to provide detailed guidance. Although this leaves much to be desired, with many open questions about how defrauded prospective plaintiffs could proceed themselves, the few decisions the SEC has made reveal a lot.
The Threshold Question: Is it a Security?
Despite many commentators describing an uncertain approach, the SEC has given a fairly clear test for when it will treat cryptocurrencies as securities and subject them to the onerous rules that come with the classification. Importantly, on June 4th, 2019, the SEC sued Kik Interactive, Inc. in relation to its sale of the digital token Kin without registration. The SEC claimed it was a security because Kik’s marketing presented it as an investment that would reap profits from Kik’s efforts, and met the traditional Howey test for investment contracts. The SEC treated another Initial Coin Offering (“ICO”) very differently. In the earlier case of Turnkey Jet, Inc.’s ICO of TKJ digital coins, the SEC issued its first no-action letter in this sphere on April 3, 2019. It deemed TKJ not a security, because the marketing did not hold it out as an investment opportunity with an expectation of profits from the company’s efforts to develop the digital infrastructure around the coin. The key component was that the coin was to be used only for buying charters, and the digital platform was already established, rather than part of an ongoing project that coin purchasers were buying themselves into to reap potential profits if and when it was successful, in contrast to Kik and their ICO of Kin. This clearly shows how TKJ was more like a currency, to be used for its function, while Kin was an investment security, and not being sold or purchased for its utility as a digital currency. Kik made statements about how its coin would increase in value due to its efforts to further develop the platform, while TKJ cautiously crafted its marketing to not take on any characteristics of a security.
These two examples offer guidance to prospective offerors of ICOs on how to avoid securities treatment, and importantly, to prospective class action securities plaintiffs attempting to convince courts that a digital coin at the heart of their suit is a security.
To recover for securities fraud when a cryptocurrency is involved, the threshold question will always be whether the digital tokens or coins are a security in the first place. The SEC guidance, the “Framework for ‘Investment Contract’ Analysis of Digital Assets,” provides a host of factors for whether a cryptocurrency will be regulated as a security. With the Howey test as a background, The SEC defines these factors to include: purchasers’ expectation of profit from the efforts of the issuer of the coin; whether a market is being made for the coin; whether the issuer is exercising centralized control over the network on which the coins are to be traded; the extent of the development of the blockchain ledger network, whether the coins are to be held simply for speculation or are to be put to a specific use; prospects for appreciation, and use as currency. This undergirds an important dichotomy that has emerged between the Existing Platform and the Developing Platform. If a cryptocurrency has a blockchain distributed ledger platform already created before money is raised through an ICO, and is run by a distributed network, then it is not likely to be defined as a security, whereas if the platform is still under development and under the management of the issuer at the time the coins are offered to the public, and is created and/or developed with the money raised in the ICO, which boosts the value afterwards, it is likely to be defined as an investment security.
Investors and the Role of Class Actions
Given the lucrative growth, volatility, and sometimes rapid declines we have seen in cryptocurrency values over the past few years, many have treated cryptocurrency as an investment, and many have suffered great losses. Cryptocurrencies, even if not on public stock exchanges, are traded with the same ease and appeal to unsophisticated retail investors as stock for Apple and Walmart. They are readily available on Coinbase, Binance, and other popular websites and apps, and a host of individuals and companies have begun releasing their own peculiar coins. Importantly, the novelty and ease of access to retail investors makes the cryptocurrency world one ripe for deceit and fraud, especially for the multitude of very volatile coins that are treated the same as securities by purchasers. As an illustration, users on Coinbase follow a chart with daily, weekly, monthly, and yearly curves showing the price movements of various digital currencies, and many treat it no differently than they would their E-trade account. Thus, this is a situation where securities class actions should take on a big role, as they are often the chief vehicles to defend the kind of diffuse harm to ordinary investors that is likely to take place with these digital coins.
Furthermore, due to the exponential growth of money held in cryptocurrencies, institutional investors are also following suit and adding them to their portfolios. According to a study released by Fidelity Investments, around half of institutional investors believe digital assets are appropriate for their portfolios.
In Balestra v. ATBCOIN, the proposed plaintiff class survived dismissal on the threshold question. The Judge found all the elements of a security met on the facts as alleged, finding that the ICO intended to raise capital to create the blockchain, and that efforts to do so by ATB would increase the value of the investment if successful. In the case of Rensel v. Centra Tech, purchasers of coins in a $32 million ICO are attempting to certify a class in their securities fraud suit. The company is already facing criminal and SEC enforcement actions for its allegedly false and misleading statements about licensing agreements it claimed to have with major credit card companies, and other alleged falsehoods. One of the main points that the proposed class focus on in their motion is whether the CTR tokens are investment contract securities, and they are trying to use the Howey test to make arguments similar to those used by the SEC against KIK: that investors in CTR invested money in the coin with an expectation of profits, there was a common enterprise with no investor control over the coin’s value, and the value was tied to the managerial efforts by Centra Tech and its executives. This threshold question will make or break the case, and whatever the court decides could set important early-stage precedent in this sparsely populated cryptocurrency sub-class of securities class actions. There are also class actions pending against Ripple and Tezos.
Facebook has recently announced their own new cryptocurrency: Libra. The statements the company released about Libra seem to take the prior SEC actions into consideration, such as presenting it as a currency with a stable value backed by deposits and low-risk government securities, rather than an investment vehicle. A potential issue stems from an audience Facebook has explicitly stated they will target, namely, those who do not use traditional banks. These individuals are the least sophisticated in financial matters, and the most vulnerable to fraud. While Facebook and others may state that their coins are currencies, they must be monitored diligently to ensure users, especially the most vulnerable, are not purchasing them as an unprotected substitute for the stock market. Securities class actions will be a viable means of protecting such individuals if things go sour with Libra or the many other ICOs already present or likely to hit the market soon.