Issuers[1] who offer and sell securities[2] in the U.S. must (a) comply with the U.S. federal securities laws, including the requirement to register with the U.S. Securities and Exchange Commission (the “SEC”) or (b) qualify for an exemption from the registration requirements of the U.S. federal securities laws.

Registration requirements apply to those who offer and sell securities in the U.S. regardless of whether the issuing entity is a traditional company or a decentralized autonomous organization, regardless of whether those securities are purchased using U.S. dollars or virtual currencies, and regardless of whether they are distributed in certificated form or through a blockchain or other distributed ledger technology.

Registration under U.S. federal securities laws requires a statutory prospectus containing information necessary to enable prospective purchasers to make an informed investment decision, a proper offering process and disclosure requirements[3]. Such information must not make untrue statements of material fact or omit to state material facts necessary in order to make the statements made, in light of the circumstances under which they were made, not misleading[4]. Similarly, the offering must not operate as a fraud or deceit upon the purchaser[5]. To date, no token sales have been registered with the SEC.

There are several exemptions to registration, each of which is subject to certain conditions. Common exemptions (including some of their conditions) that could apply to token sales are:

1. Rule 504 Offering: Offerings up to $5 million to an unlimited number of accredited investors and no more than 35 non-accredited investors;
2. Rule 506(b) Offering: Unlimited offerings to no more than 35 purchasers, provided that any non-accredited investors are financially sophisticated or have sufficient knowledge and experience in financial and business matters to evaluate the investment;
3. Rule 506(c) Offering: Unlimited offerings to an unlimited number of accredited investors;
4. Regulation A+ Tier 1 Offering: Offerings up to $20 million to an unlimited number of investors, provided the issuer files a certain exit report. Only available to companies organized in and with their principal place of business in the U.S. or Canada; and
5. Regulation A+ Tier 2 Offering: Offerings up to $50 million to an unlimited number of investors, with certain non-accredited investor investment limitations and provided the issuer files certain periodic and current reports. Only available to companies organized in and with their principal place of business in the U.S. or Canada.

Several token sales have been conducted under the above exemptions. Recent token sales have also implemented the newly proposed SAFT framework, which is an attempt at a legally compliant framework to conduct token sales. In the SAFT framework, the issuer makes an offering of securities under an exemption, which is then followed by a token sale of non-securities once the tokens are functional. However, the SAFT framework has been met with criticism and is not guaranteed to be compliant with U.S. federal securities laws as the SEC has not provided comment on this proposed framework.

On July 25, 2017, the SEC issued its first action on a token sale in its Report of Investigation Pursuant to Section 21(a) of the Securities Exchange Act of 1934: The DAO, where it applied U.S. federal securities law principles to demonstrate that a particular token constituted an investment contract and therefore was a security that should have been registered with the SEC or otherwise exempt. Specifically, based on the fact and circumstances, the SEC concluded that the token offering was a securities offering because it represented 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.

Since this action, the SEC has issued enforcement actions against the following token sales: REcoin Group Foundation and DRC World, PlexCorps and Munchee Inc. Each of these actions related to fraudulent and/or unregistered offerings and sales of securities and were brought by the SEC’s new Cyber Unit. The unit was created in September 2017 to focus on misconduct involving distributed ledger technology and initial coin offerings, the spread of false information through electronic and social media, hacking and threats to trading platforms.

The SEC’s Office of Investor Education and Advocacy, the SEC’s Division of Enforcement and the SEC’s Office of Compliance Inspections and Examinations have also issued the following investor alerts, bulletins and statements since the DAO action: Initial Coin Offerings, Public Companies Making ICO-Related Claims, Unlawful Promotion of Initial Coin Offerings and Other Investments by Celebrities and Others.

In September 2017, the SEC announced the creation of a new Cyber Unit within the Enforcement Division that will focus on, among other cyber-related issues, targeting securities violations involving ICOs. This announcement came in the wake of guidance from the SEC on the risks of investing in ICOs, as well as an illuminating report on its investigation into potential securities law violations by The DAO, an Internet-based organization that operated as decentralized venture capital fund. The SEC’s report suggests that the agency is taking a broad view concerning the application of securities laws with respect to innovative transactions involving virtual currency. Under the SEC’s analysis in the report on The DAO, any type of cryptocurrency “coin” or “token” that is exchanged for either traditional money or another cryptocurrency with the expectation of profit based on the work of others would be subject to federal securities laws. Thus, regardless of the novelty of transaction type, those involved in cryptocurrency transactions who determine that the transactions function similarly to traditional securities offerings or sales need to consider whether their offering must comply with disclosure, registration, and antifraud provisions of securities laws.

In a public statement on December 11, 2017, SEC Chairman Jay Clayton stated that the Commission applied longstanding securities law principles to demonstrate that a particular token constituted an investment contract and therefore was a security under our federal securities laws. Specifically, the SEC concluded that a token offering represents 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. Tokens and offerings that incorporate features and marketing efforts that emphasize the potential for profits based on the entrepreneurial or managerial efforts of others continue to contain the hallmarks of a security under U.S. law. While certain market professionals have attempted to highlight utility characteristics of their proposed initial coin offerings in an effort to claim that their proposed tokens or coins are not securities, the SEC has stated that merely calling a token a “utility” token or structuring it to provide some utility does not prevent the token from being a security.

The SEC has not yet provided clear guidance on the legality of different types of tokens. However, in order to protect investors and Main Street investors, the SEC encourages tokens to be registered and follow process and disclosure requirements. As of the date of the statement, though, no tokens and offerings have been registered with the SEC. The SEC cautions market participants against promoting or touting the offer and sale of coins without first determining whether the securities laws apply to those actions. Selling securities generally requires a license, and experience shows that excessive touting in thinly traded and volatile markets can be an indicator of “scalping,” “pump and dump” and other manipulations and frauds. Similarly, I also caution those who operate systems and platforms that effect or facilitate transactions in these products that they may be operating unregistered exchanges or broker-dealers that are in violation of the Securities Exchange Act of 1934[MA1] . SEC’s Division of Enforcement to continue to police this area vigorously and recommend enforcement actions against those that conduct initial coin offerings in violation of the federal securities laws.

Before launching a cryptocurrency or a product with its value tied to one or more cryptocurrencies, its promoters must either (1) be able to demonstrate that the currency or product is not a security or (2) comply with applicable registration and other requirements under our securities laws. Second, brokers, dealers and other market participants that allow for payments in cryptocurrencies, allow customers to purchase cryptocurrencies on margin, or otherwise use cryptocurrencies to facilitate securities transactions should exercise particular caution, including ensuring that their cryptocurrency activities are not undermining their anti-money laundering and know-your-customer obligations. Market participants should treat payments and other transactions made in cryptocurrency as if cash were being handed from one party to the other. Bitcoin Futures Trading The Chicago Mercantile Exchange (CME) and the CBOE Futures Exchange (CFE) on December 1, 2017 self-certified contracts for bitcoin futures products with the U.S. Commodity Futures Trading Commission (CFTC). Additionally, on this date the Cantor Exchange self-certified bitcoin binary options. Subsequently, on December 12, 2017, the CFTC published a dedicated virtual currency resource Web page that the CFTC states will act as a central bank for “Commission-produced resources about virtual currency”. It has also been reported that Nasdaq plans to launch bitcoin futures on its exchange, the Nasdaq Futures (NFX) in the first half of 2018. These launches further demonstrates the increasing acceptance of cryptocurrency into the financial mainstream. The launch of bitcoin futures trading has important implications for funds, including investment companies registered as such under the Investment Company Act of 1940 (registered funds). No publicly offered funds that provide exposure to bitcoin are yet available. A number of non-registered funds that would have traded on an exchange (ETPs) filed registration statements with the U.S. Securities and Exchange Commission (SEC), but the SEC disapproved filings made by the exchanges that would have permitted those ETPs to list and trade. The commencement of bitcoin futures trading may address some of the concerns raised by the SEC in disapproving those filings. After bitcoin futures trading began, on December 14, 2017, the National Futures Association (NFA) announced a new reporting requirement for registered commodity pool operators (CPOs) and commodity trading advisors (CTAs) that trade either or both the underlying virtual currency and virtual currency derivatives (which would include virtual currency futures, options and swaps) (collectively, virtual currency products). Effective immediately, upon commencing engaging in trading in virtual currency products in pools or accounts, registered CPOs and CTAs will need to update the portion of their annual questionnaire that addresses firm-level information which is located in the NFA online registration system (ORS), by clicking “Firm and DR Information” in the questionnaire index and answering the following questions, as applicable: CPO Questions:

• Does your firm operate a pool that has executed a transaction involving a virtual currency (e.g., bitcoin)?
• Does your firm operate a pool that has executed a transaction involving a virtual currency derivative (e.g., a bitcoin future, option or swap)? CTA Questions:
• Does your firm offer a trading program for managed account clients (other than a pool you reported under the CPO questions) that has engaged in any transaction involving a virtual currency (e.g., bitcoin)?
• Does your firm manage an account (other than a pool you reported under the CPO questions) that has executed a transaction involving a virtual currency derivative (e.g., a bitcoin future, option or swap)?

More information on this launch and the implications of Bitcoin futures trading can be found here.

End Notes

1. 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). The term “issuer” is flexibly construed in the Section 5 context “as issuers devise new ways to issue their securities and the definition of a security itself expands.”
2. The definition of “security” includes “an investment contract.” See Section 2(a)(1) of the Securities Act and Section 3(a)(10) of the Exchange Act. An investment contract is defined as (1) an investment of money, (2) in a common enterprise, (3) with a reasonable expectation of profits (4) to be derived from the entrepreneurial or managerial efforts of others. SEC v. W. J. Howey Co., 328 U.S. 293 (1946) (the “Howey Test”).
3. Section 5(a) and 5(c) of the U.S. Securities Act of 1933 (“Securities Act”).
4. Section 10(b) of the U.S. Exchange Act of 1934 (the “Exchange Act”) and Rule 10b-5.
5. Section 17(a) of the Securities Act.

Sources

• U.S. Securities Act of 1933
• U.S. Securities Exchange Act of 1934
• Rule 504 of Regulation D under the Securities Act
• Rule 506(b) of Regulation D under the Securities Act
• Rule 506(c) of Regulation D under the Securities Act
• Regulation A+ under the Securities Act
• The SAFT Project: Toward a Compliant Token Sale Framework
• CARDOZO BLOCKCHAIN PROJECT Research Report #1 NOT SO FAST—RISKS RELATED TO THE USE OF A “SAFT” FOR TOKEN SALES
• Report of Investigation Pursuant to Section 21(a) of the Securities Exchange Act of 1934: The DAO
• SECURITIES AND EXCHANGE COMMISSION v. RECOIN GROUP FOUNDATION, LLC, DRC : COMPLAINT WORLD INC. a/k/a DIAMOND RESERVE CLUB, : and MAKSIM ZASLAVSKIY
• SECURITIES AND EXCHANGE COMMISSION v. PLEXCORPS (a/k/a and d/b/a PLEXCOIN and SIDEPAY.CA), DOMINIC LACROIX and SABRINA PARADIS-ROYER
• In the Matter of MUNCHEE INC.,
• Investor Bulletin: Initial Coin Offerings
• Investor Alert: Public Companies Making ICO-Related Claims
• Statement on Potentially Unlawful Promotion of Initial Coin Offerings and Other Investments by Celebrities and Others
• New Wave of Legal Challenges for Bitcoin and other Cryptocurrencies
• SEC Public Statement on Cryptocurrencies and Initial Coin Offerings
• Bitcoin Futures Trading Commences; Implications for Funds and Registered CPOs and CTAs