In October, Yahoo Finance and Decrypt Media published a joint report stating that the U.S. Securities and Exchange Commission (SEC) had tightened the prosecution of ICOs, putting “hundreds” of projects at risk. At the same time, according to the document, dozens of companies “quietly agreed” to return investment funds and pay fines, instead of trying to come to an agreement with the regulatory requirements. Yahoo and Decrypt Media noted that there was still no regulatory clarity in the crypto space and the Commission “was not going to provide it.” On November 16, the SEC issued a statement on digital assets, one of the few such documents since the DAO report, but experts doubt that it will clarify the situation and make life easier for players in the crypto market. Our today article reviews the current sentiments of the SEC and the projects that the Commission has dealt with in November.
AirFox & Paragon
On November 16, the SEC issued a resolution on the results of the investigation regarding the AirFox and Paragon projects. The Commission found that the companies were selling unregistered securities. Now, they are obliged to register tokens in accordance with the law, pay a fine of $250,000, and meet the requirements for reimbursement of investor funds, if any.
AirFox, a financial services company, and Paragon, a blockchain startup in the marijuana industry, held their token sales last year. AirFox raised $15 million to create a mobile application that would allow users to monetize ad clicks, and Paragon raised $12 million to develop its own platform.
The companies agreed to pay fines, register their tokens as securities, and submit periodic reports to the SEC, as well as return the funds to any affected investors.
The SEC says it encourages technological innovation in the capital market, but at the same time stresses that “market participants must adhere to well-established and well-functioning legal boundaries when working in the field of technological innovation, regardless of whether they are issued in certified form or using new technologies such as blockchain.” “We have made it clear that companies that issue securities through ICOs are required to comply with existing statutes and rules governing the registration of securities,” Stephanie Avakian, the SEC’s co-director of enforcement, said. “These cases tell those who are considering taking similar actions that we continue to be on the lookout for violations of the federal securities laws with respect to digital assets.”
Global Context. The End of the “First Phase”
This is the first time that the SEC applied civil law enforcement to ICO projects, and some experts consider it to be an essential milestone in the history of crypto regulation.
“What we’re looking at is the simple progression of what was always going to happen. Regulators always step in. This always had to happen,” thinks David Silver, a lawyer in securities fraud and investment losses. “Government wasn’t going to be intimidated by a bunch of libertarians and anarchists. In the next year or two, we’ll see more than just enforcement actions.”
That was not the only important or even a turning point that took place on November 16. On the same day, the SEC summarized its current position on the activities of crypto projects in the Statement on Digital Asset Securities Issuance and Trading. “Today marks the conclusion of what I’ll call ‘phase one’ of the SEC’s crypto enforcement strategy,” commented Jake Chervinsky, a government enforcement defense and securities litigation lawyer. “This is the first since Bill Hinman’s speech saying Bitcoin and Ether aren’t securities because they’re ‘sufficiently decentralized.’ It covers all of the recent SEC enforcement actions against industry players: ICOs, exchanges, brokers, and funds. Which brings me to why I’m calling this the end of ‘phase one.’ It looks like the SEC has been building up to this statement for almost a year. They strategically prosecuted a few members of each group in order to craft this statement as guidance for everyone else.”
Chervinsky believes that the SEC is using “a classic SEC strategy known as ‘guidance by enforcement,’” which grants the regulator free rein. Marco Santori, a lawyer and author of the SAFT concept, wrote about this SEC strategy last December when the SEC announced its decision on the Munchee case: “We will see the SEC provide more guidance by enforcement. Thankfully, the agency continues to exercise its discretion and treat these as ‘teachable moments’ for those, like Munchee, who are not actually bad actors.”
Chervinsky notes that the Commission acts out of reputational interests, which may be good for it, but bad for crypto projects that need clarity and a clear legal framework: “The SEC rarely wants to test uncertain legal theories in court. If they were to lose on a big issue—like whether tokens are securities—it could disrupt their enforcement strategy for the entire industry. The best way to avoid that result? Leave the rules vague and ambiguous.” It is for this reason why Chervinsky believes that the SEC’s latest statement still does not clarify quite clearly how the securities law should apply to digital assets: “The statement asks: ‘when is a digital asset a security?’ The only answer it gives: ‘look at the DAO Report,’ even though that was issued about 16 months ago.”
The statement is “even less helpful” on the issue of decentralized exchanges whether they are subject to federal regulation, said Chervinsky. “It says this determination depends on ‘the relevant facts and circumstances.’ This is ultimate lawyer-speak for ‘not sure, don't @ us.’” “An enterprise that provides a marketplace that unites buyers and sellers of securities, regardless of the technology used, must determine whether its activities fall within the definition of an exchange in accordance with the federal securities law. Rule 3b-16 of the Stock Exchange Act provides a functional test for evaluation,” the SEC statement said. In fact, this is an analog of the Howey test for exchanges, and it is quite likely that its criteria will raise no fewer questions in crypto projects than the Howey test criteria.
Another question asked by Chervinsky, which, in his opinion, is not explained in the statement, is how far the sphere of influence of the SEC extends. “Many companies are responding to U.S. regulatory uncertainty by trying to escape the SEC’s reach. But will the SEC go after overseas ICOs and exchanges that exclude U.S. citizens? ‘Not sure, don't @ us,’” as Chervinsky comments.
At the same time, as before, the SEC remains open to direct appeals from specific projects: “Consult with legal advisers on the application of securities laws and contact the Commission’s staff if you need help,” the statement said. “There is a path to compliance with the federal securities laws going forward, even where issuers have conducted an illegal unregistered offering of digital asset securities”: this phrase from the SEC statement gives even more hope, indicating that the SEC is ready to understand projects that may not be due to criminal intent, and because of the ambiguity of the regulations, they misinterpreted the nature of the tokens being sold and agreed to pay the fine and cooperate further with the SEC.
Chervinsky notes that the upcoming second phase of regulation will probably be even more difficult for the crypto space: “If I’m right, ‘phase two’ isn’t much fun at all—it’s a slow, painful grind where the SEC cleans up the crypto space one settlement at a time. In a way, that’s the right approach. It really isn’t the SEC’s job to make the law—clarity really ought to come from Congress. And if you’re tired of hearing about regulation & enforcement, I regret to inform you this is only the start. The securities laws are just one piece of the crypto puzzle. We get to do this all over again with the laws on taxes, money laundering, sanctions, and more. Sorry.” Thus, in his opinion, other agencies are actively involved in the regulation in the second phase, in particular, the U.S. Commodity Futures Trading Commission (CFTC) and Internal Revenue Service (IRS).
SEC November: Chronology
If you believe the “theory of phases” posited by Chervinsky, then the completion of the first phase of crypto regulation was the following events:
At the beginning of November, the SEC Enforcement Department published the annual report for the 2018 fiscal year, which makes it clear that since the formation of the Cyber Division within the SEC (at the end of the 2017 fiscal year), the Commission has increasingly been engaged in identifying fraudulent activities in cyberspace, which includes ICO projects. “Over the past year, the office has opened dozens of investigations into ICOs and digital assets, many of which are ongoing.” The SEC singled out Centra Tech, Titanium Blockchain Infrastructure Services, and PlexCorps, who collectively acquired over $68 million in investment funds. According to the SEC report, the total amount of fines imposed by the Commission for the 2018 fiscal year was $3.94 billion, of which $3.04 billion accounted for 5% of the largest cases.
On November 8, the SEC filed charges against Zachary Coburn, founder of the EtherDelta exchange, which was not registered as a trading platform. The site allowed for the exchange of the ERC-20 tokens, and, according to the SEC, during the 18 months of its existence, more than 3.6 million orders were placed on the exchange, including tokens that were securities. The statement also draws attention to the fact that most of the orders were executed after the Commission had published the report of the DAO investigation in June 2017. The regulator said that the founder of the exchange, Coburn, had neither accepted nor denied the accusations, but agreed to cooperate and pay a $75,000 penalty and $313,000 in disgorgement plus interest. The SEC notes that the fine would have been more if Coburn had refused to cooperate.
On November 15, The Wall Street Journal reported that the SEC was investigating the $50 million token sale of crypto loans firm Salt Lending Holdings Inc. Sources familiar with the situation said that the company had received the subpoena in February. It is suspected of selling unregistered securities, and the Commission is investigating how the funds collected during the token sale were used and in what form Salt employees received the tokens. The SEC trial also concerns ShapeShift platform CEO Erik Voorhees, who was previously a member of the board of directors of Salt, even though in 2014, the SEC banned any fundraising activity. Whether Voorhees will cooperate with the investigation is unclear, but his previous statements do not speak in this favor. “All these stories that the government is trying to protect people are complete nonsense,” said a businessman during a summer interview with The Wall Street Journal.
On November 15, federal prosecutors of New York announced that Maxim Zaslavsky, the founder of ICO projects of the REcoin Group Foundation and the Diamond Reserve Club World, who was suspected of fraud and deception of investors, had pleaded guilty to “involving investors in the purchase of tokens through deception in the form of that they are backed by real estate and diamonds.” In fact, the certificates that he sent to investors were not related to the blockchain, and there were no supporting assets.
Recall that the case of Zaslavsky was the first thing SEC about ICO fraud. The Commission charged the businessman at the end of September 2017 and demanded to return the funds raised during the ICO and pay a fine.
Earlier, Zaslavsky insisted that the existing laws on cryptocurrency were “unconstitutionally vague” and tried to dismiss the charges against him, arguing that the cryptocurrencies he had created were not securities. This argument, however, was rejected by a federal judge of Brooklyn in September. Judge Raymond Dearie ruled that RECoin and Diamond were securities. “The calculated lies of Zaslavsky and others led unsuspecting investors who thought they were purchasing cryptocurrency securities to buy worthless certificates,” stated United States Attorney Donoghue. “This Office will continue to aggressively prosecute those who exploit and defraud investors, whether through traditional means of securities fraud, or new forms—such as the use of purported cryptocurrency offerings and blockchain technology,” said Richard Donoghue, a United States Attorney for the Eastern District of New York.