Regulation of Cryptocurrency and Initial Coin Offerings (ICOs) in United States (US)
United States (US)
US Securities Laws
In early 2017, tokens were sold in US ICOs on the assumption that they were not securities and that as “utility tokens”, they were similar to projects on Kickstarter, and thus beyond the scope of US securities laws. The position has however changed dramatically following a number of enforcement actions and statements from US regulators suggesting that most ICOs are offers of securities. As a result, many US ICO issuers now offer tokens in reliance on exemptions from the securities law registration requirement, notably under the SEC’s Regulation D which allows private placements of securities to US accredited investors, or under Regulation S which allows securities to be offered outside the US to non-US persons. There have been no registered public offerings of ICOs in the US to date.
A troubling aspect of the US regulators’ approach is that there is little clarity on whether cryptocurrencies such as Ether, Ripple, Cardano etc. could be regarded as “securities”. SEC Chairman Jay Clayton said in an interview that Bitcoin is not a security, stating that “cryptocurrencies are replacements for sovereign currencies … [they] replace the dollar, the euro, yen, with Bitcoin. That type of currency is not a security” . William Hinman in June 2018 however appeared to open the debate with respect to other cryptocurrencies, in noting how cryptocurrencies can evolve from being securities to non-securities once the network on which they function is sufficiently decentralised that purchasers no longer expect any person or group to carry out essential managerial or entrepreneurial efforts (a requirement under the “Howey test” as discussed below). He stated that he did not consider Ether to be a “security” given the present state of Ether, the Ethereum network and its decentralised structure (where the efforts of a third party are no longer a major factor in ensuring the enterprise’s success). He however specifically left out of his analysis the fundraising that accompanied Ether’s creation. Ripple Labs, Inc., the issuer of Ripple coin (XRP) one of the largest cryptocurrencies, is facing a number of class action law suits alleging that Ripple violated federal and state securities laws in offering unregistered securities to the public.
The DAO Investigative Report
Since the publication of the DAO investigative report in July 2017 by the US Securities and Exchange Commission (the SEC), the US regulators’ scrutiny of ICOs has intensified. The DAO investigative report determined that “DAO Tokens” offered and sold by a “virtual” organisation called the DAO were “securities” under the Securities Act of 1933 and the Securities Exchange Act of 1934, and were thus required to be registered with the SEC unless a valid exemption applied. DAO Tokens were offered in exchange for Ether (ETH) and the ETH raised would be used to fund projects. DAO Token holders stood to share in the expected profits from these projects as a return on their investment in DAO Tokens.
The SEC applied the “Howey test” to determine that the DAO Tokens were “investment contracts”, a type of security under US securities law. Under the test, an “investment contract” is 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.
The SEC found that the DAO was an investment contract:
- “an investment of money”Investors in the DAO used ETH to make their investments. The investment of “money” does not need to take the form of cash, and investment may take the form of goods and services, or some other exchange of value. It had previously been held that an investment of Bitcoin meets this first prong of the test.
- “in a common enterprise with a reasonable expectation of profits”Purchasers of DAO were found to be investing in a common enterprise and reasonably expected to earn profits through that enterprise when they sent ETH to the DAO’s Ethereum blockchain address in exchange for DAO Tokens. Profits include “dividends, other periodic payments, or the increased value of the investment”.Promotional materials distributed by Slock.it (the platform’s creator) and its co-founders informed investors that the DAO was a for-profit entity whose objective was to fund projects in exchange for a return on investment. Depending on the terms of each particular project, DAO Token holders stood to share in the potential earnings from projects funded by the DAO. A reasonable investor would thus have been motivated, at least in part, by the prospect of profits on their investment of ETH in the DAO.
- “to be derived from the entrepreneurial or managerial efforts of others”
- The Efforts of Slock.it, Slock.it’s Co-Founders, and The DAO’s Curators Were Essential to the EnterpriseThe DAO’s investors relied on the efforts of Slock.it and its co-founders and curators to manage the DAO and put forward project proposals. The issue was whether their efforts were essential managerial efforts which affect the failure or success of the enterprise.Investors’ expectations were primed by the marketing of the DAO as well as the active engagement between Slock.it and its co-founders with the DAO and DAO Token holders (via the DAO website and online forums). The creators of the DAO held themselves out to be experts in Ethereum, and informed investors that curators were selected based on their expertise and credentials. Through their conduct and marketing materials, Slock.it and its co-founders led investors to believe that they could be relied on to provide the significant managerial efforts necessary to make the DAO a success.Curators vetted contractors who submitted proposals, determined whether and when to submit proposals for votes, determined the order and frequency of proposals submitted for vote, and determined whether to halve the default quorum for a successful vote for specific proposals. Thus, proposals were subject to control by the curators, and the curators exercised significant control over the order and frequency of proposals.
- DAO Token Holders’ Voting Rights Were LimitedVoting rights did not provide token holders with meaningful control over the enterprise. Their ability to vote was largely perfunctory, and there were indications that proposals would not have necessarily provided investors with sufficient information to make an informed decision. In addition, the pseudonymity and dispersion of token holders rendered it difficult for holders to join together to effect change or to exercise meaningful control. DAO token holders’ voting rights were akin to those of a corporate shareholder.It was determined that DAO Token holders relied on the significant managerial efforts of Slock.it and its co-founders, and the DAO’s Curators. Their efforts were “undeniably significant” and essential to the overall success and profitability of any investment into the DAO.The SEC stated that whether a particular transaction involves the offer and sale of a security will depend on the facts and circumstances, including the economic realities of the transaction.
Enforcement actions after the DAO Report
The SEC has brought a number of enforcement actions since the DAO report, including a large number of actions for fraud including:
- Actions alleging the defrauding of investors in ICOs by Recoin Group Foundation and DRC World which purported to be backed by real estate and diamond investments. The existence of the businesses was allegedly fabricated by the defendants and promises of significant returns to investors were unsubstantiated; and
- An action against PlexCorps in relation to its ICO of its cryptocurrency “PlexCoin” which had made fraudulent misrepresentations including a promise of a vastly exaggerated investment return to pre-sale purchasers (1,354% in 29 days or less).
In December 2017, the SEC halted the ICO of Munchee Inc. (Munchee) for violations of US securities laws. The case shows that the SEC will intervene where it believes there has been a breach of securities laws even when there is no fraud involved. The case is interesting in that it apparently involved a “utility token” issued to raise funds for the improvement of an existing app. The SEC determined  that the MUN tokens were investment contracts under the Howey test. Relevant factors included the following:
- Representations were made in the whitepaper and elsewhere that the MUN tokens would increase in value. The whitepaper stated that a tiered membership plan under which holders of greater numbers of tokens would receive more tokens as payment for reviews and Munchee potentially “burning” tokens in the future taking them out of circulation would reduce the supply of the tokens, potentially causing the appreciation of the remaining tokens. Munchee and its agents also made statements on blogs and podcasts that the tokens would increase in value and endorsed other people’s public statements that touted the opportunity to profit. For example, Munchee created a public Facebook posting linked to a third-party YouTube video suggesting how pre-sale investors would likely profit from the ICO;
- Munchee intended that the tokens would trade on a secondary market, representing in the whitepaper that they would be tradable on at least one US-based exchange within 30 days of the conclusion of the offering; and
- The tokens were marketed to crypto-investors (i.e. people with an interest in tokens and digital assets that had created profits for early investors), rather than to existing users of the Munchee App or to the restaurant industry (the supposed intended users of the tokens).
The SEC found that the proceeds of the ICO were intended to be used by Munchee to improve an existing App and to build an ecosystem that would create demand for the tokens which would make them more valuable.
The decision also noted that even if the tokens had had a practical use at the time of the offering, this would not preclude them from being a security. The determination of whether or not a token is a “security” depends on an assessment of “the economic realities underlying a transaction” and not the label it is given (e.g. a “utility token”).
Recent Statements by US Regulators
SEC Corporate Finance Division Director, William Hinman  expressed the view that in many cases where promoters raise money to develop networks on which digital assets will operate through an ICO, the economic substance is the same as a conventional securities offering. He noted that “Funds are raised with the expectation that the promoters will build their system and investors can earn a return on the instrument – usually by selling their tokens in the secondary market once the promoters create something of value with the proceeds and the value of the digital enterprise increases”. The SEC generally regards ICO tokens as well as simple agreements for future tokens, or SAFTs, as securities for the purposes of federal securities laws. It thus appears that the analysis of whether or not a cryptocurrency is a security is not determined by technological or technical distinctions.
ICOs vary widely, and whether or not a particular ICO falls within the definition of a “security” will be fact specific.
Regulation of Crypto Exchanges
A trading platform which offers trading of cryptocurrencies which are “securities” and operates as an “exchange” as defined under Federal securities laws must be registered with the SEC as a national securities exchange or be exempt from registration . An exemption is available for an alternative trading system which is registered with the SEC as a broker-dealer and becomes a member of a self-regulatory organisation such as the Financial Industry Regulatory Authority.
There have been media reports that several cryptocurrency exchanges have entered into talks with the SEC about registering as a licensed broker-dealer, but these have not been approved at the date of writing.
The SEC has also noted that trading platforms which do not meet the definition of an “exchange”, but which transact in cryptocurrencies that are securities, or offer digital wallet services to hold them, may trigger other registration requirements including broker-dealer, transfer agent, or clearing agency registration. A platform that offers cryptocurrencies that are securities, may also participate in an unregistered offer and sale of securities if no exemption applies.
If a sale of coins involves a “virtual currency”, the US Department of the Treasury, Financial Crimes Enforcement Network (FinCEN) regulations may apply. FinCEN guidelines issued in March 2013 define “virtual currency” as “a medium of exchange that operates like a currency in some environments, but does not have all the attributes of real currency. In particular, virtual currency does not have legal tender status in any jurisdiction” . Those guidelines provide that “administrators” and “exchangers” of convertible virtual currencies are considered to be “money transmitters” and therefore “money service businesses” (MSBs) which are required to register with FinCEN and comply with federal laws and regulations aimed at countering money laundering and terrorist financing (AML and CTF). An “administrator” is “a person engaged as a business in issuing (putting into circulation) a virtual currency, and who has the authority to redeem (to withdraw from circulation) such virtual currency”. An “exchanger” is “a person engaged as a business in the exchange of virtual currency for real currency, funds, or other virtual currency”.
In February 2018, FINCEN wrote to a member of the Senate Committee on Finance  indicating that it considers certain persons participating in ICOs including ICO issuers and exchanges trading ICO tokens to be money transmitters required to register with FinCEN and comply with federal AML and CTF laws and regulations.
The US Commodity Futures Trading Commission (CFTC) has designated Bitcoin as a commodity. The CFTC thus has oversight of fraud and manipulation involving Bitcoin traded in interstate commerce as well as the regulation of commodity futures tied directly to Bitcoin .
On 18 January 2018, the SEC issued a staff letter  outlining investor protection issues they consider relevant in considering the suitability of exchange traded funds (ETFs) which invest in cryptocurrencies for retail offering. The key concerns outlined related to valuation, the necessary liquidity to enable daily redemptions, custody arrangements, complying with the obligation to ensure an ETF’s market price does not deviate materially from its net asset value and risks of fraud and market manipulation. The staff letter came in response to applications for SEC approval of ETFs investing in bitcoin, which have so far been denied. On 24 August 2018, the SEC rejected nine applications to list ETFs backed by Bitcoin. Key concerns cited by the regulator were the potential for price manipulation and fraud.
Note: The above represents Charltons’ current understanding of the regulation of ICOs in different jurisdictions. Charltons advises only on Hong Kong law and while the above represents our understanding of the legal position in certain other jurisdictions, legal advice from qualified lawyers in the relevant jurisdictions should be sought in relation to any particular transaction or situation. Further, this note is intended for educational purposes and it does not constitute Hong Kong legal advice. Specific advice must be sought in relation to any particular situation.
- CNBC. “SEC chief says agency won’t change securities laws to cater to cryptocurrencies”. <https://www.cnbc.com/2018/06/06/sec-chairman-clayton-says-agency-wont-change-definition-of-a-security.html>
- Order instituting cease-and-desist proceedings pursuant to section 8A of the Securities Act of 1933, making findings, and imposing a cease and desist order. 11 December 2017. <https://www.sec.gov/litigation/admin/2017/33-10445.pdf>
- William Hinman. “Digital Asset Transactions: When Howey Met Gary (Plastic)”. 14 June, 2018. Note both statements are expressed as representing the views of the speaker rather than the SEC.
- SEC. “Statement on Potentially Unlawful Online Platforms for Trading Digital Assets”. 7 March 2018. <https://www.sec.gov/news/public-statement/enforcement-tm-statement-potentially-unlawful-online-platforms-trading>
- FinCEN. “Application of FinCEN’s Regulations to Persons Administering, Exchanging, or Using Virtual Currencies.” 18 March 2013. <https://www.fincen.gov/resources/statutes-regulations/guidance/application-fincens-regulations-persons-administering>
- Letter to the Honorable Ron Wyden, Ranking Member of the Committee on Finance. 13 February 2018. <https://coincenter.org/files/2018-03/fincen-ico-letter-march-2018-coin-center.pdf>.
- SEC Chairman, Jay Clayton. “Statement on Cryptocurrencies and Initial Coin Offerings”. 11 December 2017. <https://www.sec.gov/news/public-statement/statement-clayton-2017-12-11>
- US Securities and Exchange Commission. “Staff Letter: Engaging on Fund Innovation and Cryptocurrency- related Holdings”. 18 January 2018. <https://www.sec.gov/divisions/investment/noaction/2018/cryptocurrency-011818.htm>